hurdles of different heights for securities fraud litigants of different

HURDLES OF DIFFERENT HEIGHTS FORSECURITIES FRAUD LITIGANTS OF

DIFFERENT TYPES

Jonathan D. Glater*

Fraud claims filed by investors in the wake of thefinancial crisis of 2008 reveal a significant and unrecognizedproblem in securities law: the law treats claims of investorswho purchase securities through private placements morefavorably than it treats claims of investors who purchaseshares on public exchanges or in public offerings. Thedisparity is a symptom of financial markets outpacing theirlegal and regulatory framework, and this Article proposes aremedy.

The different hurdles confronting investors who invest indifferent transactions but who make similar allegations andrely on the same law are, the Article contends, an unfair andapparently unintended result of the Private SecuritiesLitigation Reform Act of 1995 ("PSLRA'), which sought tocurb frivolous shareholder class actions. The PSLRA raisedthe standard plaintiffs must meet in alleging that adefendant had wrongful intent, or scienter, but it did not

* Assistant Professor of Law, University of California, Irvine. Theauthor wishes to thank Frank Partnoy, Christopher Leslie, OlufunmilayoB. Arewa, Margaret V. Sachs, Lawrence G. Baxter, Deborah A. DeMott,Elbert L. Robertson, Michael Perino, participants in the fall 2013University of California, Irvine School of Law - University of California,Berkeley School of Law Junior Faculty Exchange, participants in the 2013Workshop for Corporate and Securities Litigation, participants in the 2012John Mercer Langston Law Faculty Writing Workshop, Stephen Rich,Sarah Lawsky, Stephen Lee, Christopher Whytock, Alejandro Camachoand Kenneth Stahl for help refining the ideas in this article. The author isdeeply indebted to Brendan Starkey, Joy Shoemaker, Christina Tsou, andJackie Woodside of the University of California, Irvine Law Library fortheir expert research assistance; to my research assistant, CatrionaLavery, for her hard work reviewing dozens upon dozens of securitiesfraud cases; and to the staff of the Columbia Business Law Review fortheir diligence and care.

raise the standard applicable to claims that a plaintiffreasonably relied on an allegedly fraudulentmisrepresentation or omission. Because establishing scienteris difficult for investors with access only to regulatorydisclosures by publicly traded companies, while establishingreasonable reliance is more likely to be difficult for putativelysophisticated investors in private placements, investors inpublicly accessible transactions face a higher hurdle thanprivate placement investors when alleging fraud.

This Article describes and critiques this effect of thePSLRA, and calls on Congress to revise standards so thatinvestors victimized by fraud have the same chance ofrecovery through litigation whether or not they purchasedsecurities in a private placement.

I. Introduction ................................. 49II. The Role of Private Securities Litigation ..... ..... 55

A. The Costs of the Private Right of Action ............ 57B. The Benefits of the Private Right of Action......61C. The Multiple Paths Permitting Private

Securities Litigation .................. ..... 63III. The Path to Recovery Through Section 10(b)

Securities Litigation ..................... 66A. The Elements of a Claim of Fraud Under the

Exchange Act.........................681. Scienter ......................... 702. Reliance. .......................... ..... 723. Loss causation ..................... ..... 77

B. The Federal Rules of Civil Procedure ..... ...... 78C. The PSLRA ......................... ...... 79

IV. Implications of Selectively Raising PleadingStandards for Outsider Investors ................ 87A. Selectively Raising Pleading Standards

Burdens Outsider Investors ................. 881. Outsider Investors' Difficulty Developing

Evidence of Scienter ..................... 902. Connected Investors' Allegations of Reliance

Face a Less Demanding Standard .... ...... 93

48 COLUMBIA BUSINESS LAW REVIEW [Vol. 2014

HURDLES OF DIFFERENT HEIGHTS

B. Negative Consequences of Favorable PleadingStandards for Connected Investors . ........... 971. Lower Reliance Standards May Discourage

Investor Care ..................... 972. Raising Pleading Standards for Outsider

Investors as Part of the Trend ofRestricting Civil Recovery ..... ........... 99

V. Proposing New Standards ............ ......... 103A. Reducing the Hurdle's Height for Pleading

Scienter. .......................... ...... 103B. Reforms Are Possible................. ...... 107

VI. Conclusion......................... ........ 108

I. INTRODUCTION

In the wake of the 2008 financial crisis, investors whosuffered losses did what investors often do-they filedlawsuits. Many were shareholder class action suits allegingthat companies failed to disclose the scale of their potentialexposure to losses caused by falling real estate prices' andrising rates of borrower delinquency.2 However, many were

1 See Shaila Dewan, Housing Recovery Seems Still on Track, N.Y.TIMES, Sept. 25, 2013, at B1 (reporting home prices rising after severalyears of declines following the financial crisis of 2008).

2 Rates of delinquency on home loans-the number of loans on whichborrowers are at least one payment past due-increased through therecession that followed the financial crisis of 2008, then slowly started todecline two years later, as reflected in data released by the MortgageBankers Association. See Press Release, Mortgage Bankers Association,Delinquencies and Foreclosures Increase in Latest MBA NationalDelinquency Survey (Sept. 5, 2008) (on file with author), available athttp://www.mba.org/NewsandMedia/PressCenter/64769.htm; PressRelease, Mortgage Bankers Association, Delinquencies Continue to Climbin Latest MBA National Delinquency Survey (Nov. 19, 2009) (on file withauthor), available at http://www.mba.org/NewsandMedia/PressCenter/71112.htm; Press Release, Mortgage Bankers Association,Delinquencies and Loans in Foreclosure Decrease, but Foreclosure StartsRise in Latest MBA National Delinquency Survey (Nov. 18, 2010) (on filewith author), available at http://www.mba.org/NewsandMedia/PressCenter/74733.htm.

No. I1:47] 49

individual actions filed by financial companies that hadpurchased various types of securities, 3 which fell in value asa result of the same trends; the plaintiffs alleged that thesellers did not disclose the riskiness of the securities. Thetwo types of investor litigation frequently relied on the samefederal law, section 10(b) of the Securities Exchange Act of1934 (the "Exchange Act"),4 and arose out of the same or verysimilar facts. Yet the hurdles confronting plaintiffs weredifferent depending on the circumstances of the purchase.Pleading standards favor investors who bought throughprivate placements, making recovery through litigationpotentially easier for these investors relative to investorswho did not buy through private placements.

An investor who files a lawsuit alleging fraud afterpurchasing shares of a publicly traded company, either in aninitial public offering ("IPO") or on an exchange, cantypically draw on general information about the companyfrom executives' public statements, periodic reports, or, inthe case of an IPO, from registration materials filed withregulators.' An investor who files a lawsuit alleging fraudafter purchasing securitieS6 through a private placement (atransaction available essentially by invitation only)' can

3 Some investor plaintiffs who purchased through private placementsalso sought class action status. See, e.g., Argent Classic ConvertibleArbitrage Fund L.P. v. Countrywide Fin. Corp., No. CV 07-07097 MRP,2009 WL 8572340 (C.D. Cal. Mar. 19, 2009) (plaintiff investors seeking torepresent a class of all purchasers of convertible debentures issued byCountrywide Financial Corp.).

4 Securities Exchange Act of 1934 § 10(b), 15 U.S.C. § 78j (2012).5 These disclosures identify the expected uses of the money raised by

the offering, state corporate financial status and performance, specifymaterial contracts, and provide other information about the company andits business. See 15 U.S.C. § 77aa.

6 This includes shares or preferred shares-a public company may sellsecurities through a private placement, too.

7 The Securities and Exchange Commission ("SEC") has released newrules governing private offerings, permitting general solicitation ofinvestors. See Eliminating the Prohibition Against General Solicitationand Advertising in Rule 506 and Rule 144A Offerings, Securities ActRelease No. 33-9415, 78 Fed. Reg. 44,771 (July 10, 2013). While such

50 COL UMBIA B USINESS LA W RE VIE W [Vol. 2014

draw on transaction-specific information that is moredetailed and relevant than disclosures in an annual report,for example. That more specific information demonstrates,at a minimum, a defendant seller's interest in persuadingthe plaintiff to invest.8 This Article contends that thisinformation disparity puts the second plaintiff in a betterposition to provide a sufficiently persuasive story to satisfythe pleading requirements applicable to claims under section10(b). The hurdle for an investor who bought on anexchange or in an IPO is too high, while the hurdle for theinvestor who bought through a private placement is too low.Overall, the disparity is one more way that the law createsan incentive to use private placements.

The difference in treatment of claims arising fromdifferent types of transactions is a symptom of a largerproblem, that of financial markets outpacing their legal andregulatory framework. Congress was concerned withprotecting public company shareholders when it adopted theantifraud provisions of the Exchange Act.9 Lawmakers didnot offer a rationale for discriminating against investors whobuy shares of companies through transactions accessible tothe investing public compared to investors in private

solicitation is now permitted, participation in the private placement is stillrestricted to accredited and/or sophisticated investors.

8 Prior to a private placement, potential buyers typically receivedocumentation describing the transaction in detail. Buyers may attendpresentations on the securities to be sold and may ask for and receiveadditional information to enable better analysis of the securities' valueand riskiness. See infra Section TV.A.

9 See Steve Thel, The Original Conception of Section 10(b) of theSecurities Exchange Act, 42 STAN. L. REV. 385, 394-95 (1990) (describinghow in the years before the adoption of the Exchange Act, "pressure wasmounting for public control of the practices of those who sold corporatesecurities to public investors"). Private offerings have grown inimportance in recent years; in 1981, about $12 billion of securities wereoffered through private placements, while in 2010, the figure exceeded$900 billion. See Elisse B. Walter, Comm'r, SEC, Remarks at the 2011SEC Government-Business Forum on Small Business Capital Formation(Nov. 17, 2011) (transcript available at http://www.sec.gov/news/speech/2011/spch111711ebw.htm).

No. I1:47]1 HURDLES OF DIFFERENT HEIGHTS 5 1

placements.10 Subsequent legislative action that hindersshareholder lawsuits is the result of advocacy for restrictionsthat protect public companies from potentially costlylitigation.

This Article argues that disparate treatment of investorsin publicly accessible transactions, as compared to investorsin instruments sold through private transactions, not onlylacks justification, but in fact may undermine protection ofinvestors who are more vulnerable to fraud. Investors thatbuy shares through a publicly accessible transaction (hereinreferred to as "outsider" investors) typically receive lessdetailed and less transaction-specific information than doprivate placement investors ("connected" investors). Becauseof the different information provided to them, outsiderinvestors may have more difficulty assessing the likelihoodof fraud. If pleading standards hinder outsider investors'"efforts to recover through litigation, relative to otherinvestors, then the standards further weaken investorsalready at an informational disadvantage and reduce thelikelihood of realizing positive externalities that somescholars have identified as benefits of shareholder lawsuits.12The disparity matters because of the rapid growth in privateofferings in recent years and the increasing frequency ofparticipation in such investments by institutions like publicpension funds.13

10 The Supreme Court has addressed the private right of action underthe Exchange Act in oblique fashion, without articulating a rationale thatmight explain differential treatment. See Superintendent of Ins. of N.Y. v.Bankers Life & Cas. Co., 404 U.S. 6, 13 n.9 (1971) (observing in a footnotethat "[iut is now established that a private right of action is implied under§10(b)" and citing two prior Supreme Court cases, only one of which(Tcherepnin v. Knight, 389 U.S. 332 (1967)) involved a § 10(b) claim; thatcase also took for granted that a private right of action existed).

11 In this Article, "shareholders" refers to investors who hold shares ofpublicly traded companies, when those shares were purchased through atransaction available to the investing public.

12 See infra Part II.B.'3 See Viad Ivanov and Scott Bauguess, Capital Raising in the U.S.:

The Significance of Unregistered Offerings Using the Regulation DExemption, 1, 3 (Feb. 2012),



Litigation between buyers and sellers in privateplacements has received less scholarly attention thanshareholder class actions; post-private placement litigationclearly benefits the successful plaintiff but less obviouslyhelps anyone else.14 This Article proposes an overhaul ofpleading standards applicable to fraud claims to ease thepath to recovery for plaintiffs with less pre-transactionaccess to information and to make more precise the pleadingrequirements that investors with relatively greater access toinformation must meet. This Article is a building block in alarger project exploring the implications of the evolution ofthe financial markets, a topic approached from differentangles by scholars including Steven L. Schwarcz, 15 StevenDavidoff, 6 Usha Rodrigues,1 7 and Elizabeth Pollman,"

http://www.sec.gov/info/smallbus/acsec/acsecl03111_analysis-reg-d-offering.pdf (finding that, for example, private offerings pursuant toRegulation D raised more capital than did debt offerings in 2010; suchofferings also raised more than twice as much as public equity offerings).

14 Indeed, I will argue that these lawsuits, when decided wrongly orperhaps even inconsistently, may create a negative externality by affectingthe incentives of parties to securities transactions to disclose or to conductdue diligence. See infra Part IV.B.1.

15 See, e.g., Steven L. Schwarcz, Disclosure's Failure in the SubprimeMortgage Crisis, 2008 UTAH L. REV. 1109, 1115 (2008) (questioning theefficacy of a securities regulation regime that makes disclosure a prioritywhen the financial crisis suggests that purchasers of risky securities didnot understand the information disclosed).

16 See, e.g., Steven M. Davidoff, Paradigm Shift: Federal SecuritiesRegulation in the New Millennium, 2 BROOK. J. CORP. FIN. & COM. L. 339,340 (2008) (describing changes in capital markets as a result of growth ofprivate exchanges, growing role of institutional investors and rapidinnovation, and identifying failures of federal securities regulation to keeppace).

17 Professor Rodrigues has cited the growth in exempt transactions incalling for greater access by retail investors to private placements. SeeUsha Rodrigues, Securities Law's Dirty Little Secret, 81 FORDHAM L. REV.

3389, 3417-23 (2013).18 Professor Pollman has raised a host of difficult questions about the

implications of secondary markets for trading of shares of privately heldcompanies, another financial market innovation that poses a challenge tothe existing law and regulation of securities. See Elizabeth Pollman,Information Issues on Wall Street 2.0, 161 U. PA. L. REV. 179, 206 (2012).

No. I1:47] 53

among others. It also attempts to evaluate how well currentlegal and regulatory mechanisms protect investors andenhance stability for the identification of potential securitiesfraud. The Article links these conversations withinsecurities law and conversations outside of securities lawinvolving access to justice and raises questions about who isbest placed to prevent, or at least detect, fraud. In a futurearticle, I intend to examine the role that the regime forclassification of accredited investors may have played in thefinancial crisis and propose reforms.

The following discussion has five parts. Part II describescriticisms and offers justifications for private securitieslitigation. The difference in pleading standards confrontingplaintiffs in securities fraud cases raises a significant anddifficult question: What is the proper role of private litigationin constraining financial market misconduct? Answeringthat question is not easy, although it is clear that privatelitigation represents an important ex post response to fraud.Part II describes criticisms of securities fraud lawsuits andoffers a defense. This Part then situates the remedy affordedby section 10(b) in the context of other private rights ofaction for securities fraud.

Part III describes the pleading standards that fraudclaims under the Exchange Act must meet in order tosurvive a motion to dismiss. Because these cases do notoften go to trial,19 resolutions of motions to dismiss matter,and defeating such a motion preserves the possibility ofdamages, while a loss precludes recovery. This Partidentifies the elements of a fraud pleading that often provecritical to surviving a motion to dismiss. The description ofthe elements of a securities fraud claim and of the evolutionof the applicable pleading regime is a significant contributionof this Article.

Part IV describes the effects of the different pleadingstandards on different kinds of plaintiffs. This Part explainshow the standards may be more or less difficult to satisfy,

19 See S. REP. No. 104-98, at 9 (1995), reprinted in 1995 U.S.C.C.A.N.679, 688.



depending on the characteristics of the investment that gaverise to litigation. Additionally, Part IV argues thatCongress's selective raising of the pleading standardsapplicable to claims of securities fraud unfairly andunjustifiably blocks access to justice for outsider investors.Finally, this Part situates barriers to certain securities fraudclaimants within a broader trend, recognized by othercommentators on civil pleading standards, toward moretightly restricted access to courts. The animating concern ofthis Article is that the disparity in access to redress throughlitigation matters. Investors in private placements have anadvantage that may translate into greater settlement valuesin the wake of allegations of fraud.2 0

Part V contends that disparate treatment of differentfraud claims is the result of a failure to update laws andregulations to keep up with changes in financial markets.This Part proposes reforming pleading standards to reducethe height of the hurdles confronting outsider claimants infraud lawsuits, and to make more precise courts' evaluationsof the reasonableness of connected plaintiffs' reliance on adefendant's allegedly fraudulent statements. The proposalbriefly outlines what might be required of sophisticatedinvestors claiming they were victims of deceit and discussesthe political economy of any reform effort.

II. THE ROLE OF PRIVATE SECURITIESLITIGATION

For decades, the Supreme Court has recognized a privateright of action under section 10(b) of the Exchange Act,although the law does not explicitly provide for civil lawsuitsby investors.2 1 Private securities litigation has proven

20 It may be that, with the continuing rise of institutional investors,investors buying through publicly accessible transactions and investors inprivate placements are increasingly often the same entities. Even if theinvestor populations were the same, the disparity in treatment still wouldbeg a rationale.

21 Then-Justice William Rehnquist described private securitieslitigation under section 10(b) as a "judicial oak which has grown from littlemore than a legislative acorn." Blue Chip Stamps v. Manor Drug Stores,

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controversial. Critics complain that investor lawsuitsneither punish nor deter actual or potential wrongdoers anddo not compensate anyone other than plaintiffs' lawyers.2 2

The critics making these arguments include executives atcompanies named as defendants in fraud lawsuits, 23 scholarswho have studied the effects of litigation,2 4 and groupsadvocating stricter control of civil litigation more generally. 2 5

421 U.S. 723, 737 (1975). Eight years later, Justice Thurgood Marshallfamously wrote that the "existence of this implied remedy is simply beyondperadventure." Herman & MacLean v. Huddleston, 459 U.S. 375, 380(1983).

22 For example, the American Tort Reform Association, a groupadvocating changes to laws governing civil litigation generally, called forinvestigation of "widespread misconduct by the plaintiff's bar" after twoleading securities class action lawyers were convicted of various crimesrelated to their practice of law. Press Release, American Tort ReformAssociation, Weiss Sentencing Prompts ATRA to Again Press Congress forHearings Into Potentially Widespread Trial Lawyer Misconduct (June 2,2008) (on file with author), available athttp://www.atra.org/newsroom/weiss-sentencing-prompts-atra-again-press-congress-hearings-potentially-widespread-trial.

23 See, e.g., Common Sense Legal Reforms Act: Hearing Before theSubcomm. on Telecomm. and Fin. of the Comm. on Commerce, 104th Cong.87-92 (1995) (statement of Dennis W. Bakke, President and ChiefExecutive Officer, AES Corp.) (criticizing the securities laws forempowering "a new class of bully - the class action, securities law plaintiffattorney"). Bakke was a named defendant in, among others, Stafford v.Bakke, No. 1:03CV1132-LJM-WTL, 2005 WL 1656855, (S..D. Ind. July 7,2005).

24 See, e.g., Eric Helland, Reputational Penalties and the Merits ofClass-Action Securities Litigation, 49 J.L. & EcON. 365, 366 (2006) (findinglittle evidence that allegations of fraud impose a "reputational penalty" ondirectors when boards to which they belong are accused of fraud); A.C.Pritchard, Stoneridge Investment Partners v. Scientific Atlanta: ThePolitical Economy of Securities Class Action Reform, 2008 CATO SUP. CT.REV. 217, 225 (warning that "[c]ourts and jurors, with hindsight, may havedifficulty distinguishing false statements (which were known to be false atthe time) from unfortunate business decisions").

25 For example, the U.S. Chamber of Commerce has advocatedchanges that would affect securities fraud claimants. See U.S. CHAMBEROF COMMERCE, SECURITIES CLASS ACTION LITIGATION: THE PROBLEM, ITSIMPACT, AND THE PATH TO REFORM 2 (2008), available athttp://www.thehill.com/sites/default/files/ILR_2008SecuritiesClassActionLitigation_0.pdf.

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Their arguments may explain lawmakers' readiness to adoptlegislation aimed at curtailing securities litigation2 6 and thehostility expressed by some Supreme Court justices towardsecurities class action suits.2 7 In several cases, the SupremeCourt has imposed strict standards on securities fraudplaintiffs' claims, which this Article explores in Part III.

This Part describes some of the virtues of privatesecurities litigation, first briefly describing its role inconjunction with other regulatory mechanisms, then offeringa response to criticisms. This Part contends that higherhurdles to shareholder litigation have reduced theeffectiveness of post-fraud private litigation as a regulatorytool.

A. The Costs of the Private Right of Action

There are three rationales traditionally used to justifyprivate securities litigation: deterrence of wrongdoing,punishment of wrongdoers, and compensation of victims.28

Deterrence and punishment in the context of financialmarkets may have an added benefit, imposing discipline on

26 Congress in the 1990s passed two major laws aimed at curbingsecurities class action litigation. See Private Securities Litigation ReformAct of 1995, Pub. L. 104-67, 109 Stat. 737 (codified in scattered sections of15 U.S.C.); Securities Litigation Uniform Standards Act of 1998, Pub. L.105-353, 112 Stat. 3227.

27 Just a few years after the footnote acknowledging the private rightof action under section 10(b) was written, supra note 10, the Court warnedof the "danger of vexatious litigation which could result from a widelyexpanded class of plaintiffs." Blue Chip Stamps v. Manor Drug Stores,421 U.S. 723, 740 (1975). The Court has cited that same language in morerecent opinions criticizing and limiting the scope of 10(b) liability. SeeStoneridge Inv. Partners, LLC v. Scientific Atlanta, Inc., 552 U.S. 148, 163(2008) (citing Blue Chip Stamps for "not[ing] that extensive discovery andthe potential for uncertainty and disruption in a lawsuit allow plaintiffswith weak claims to extort settlements from innocent companies").

28 See Merritt B. Fox, Why Civil Liability for Disclosure ViolationsWhen Issuers Do Not Trade?, 2009 Wis. L. REV. 297, 299-300 (2009)(discussing compensation and deterrence); Laura A. McDonald, Note,Restoring the Balance After the Private Securities Litigation Reform Act of1995, 38 FLA. ST. U. L. REV. 911, 915 (2011) (discussing punishment).

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seller and investor conduct. There are two more implicitjustifications, both so obvious that they may often beforgotten: detection and fairness. These goals underlie theprivate cause of action under provisions of a different law,sections 11 and 12 of the Securities Act of 1933 (the"Securities Act"), 2 9 which permit investors to sue based onmisrepresentations or omissions in a registration statementor prospectus, respectively.30

The private right of action for recovery in cases ofsecurities fraud complements industry self-regulatoryregimes, 31 as well as government civil and criminalregimes. 3 2 The Financial Industry Regulatory Authority("FINRA"), an industry self-regulatory organization, mayimpose monetary penalties. 33 The Securities and ExchangeCommission ("SEC") may sue under the same provisionavailable to private litigants.34 State and federal prosecutorsmay pursue criminal charges against wrongdoers whose

29 Securities Act of 1933 §§ 11, 12, 15 U.S.C. §§ 77k, 771 (2012).30 For a more complete discussion of these other potential causes of

action, see infra Part II.C.31 Professor Fox has argued that perhaps the enforcement regime

should be viewed the other way around: public enforcement complementsprivate litigation. See Fox, supra note 28, at 328-29. The proper framingof the relationship between public and private enforcement does not alonerespond to criticism of investor securities litigation.

32 In addition to these ex post remedies for fraud, other mechanismsseek to prevent fraud ex ante. Independent auditors review financialstatements of public companies, for example, and lawyers advise on whatinformation must be disclosed when.

33 Since 2010, FINRA has investigated and prosecuted potentialmisconduct by members of public stock exchanges on behalf of theexchanges. FINRA may impose monetary penalties on their members forviolations of exchange rules and applicable laws. See NYSE DisciplinaryActions, NYSE EURONEXT, https://usequities.nyx.com/regulation/disciplinary-actions (last visited Mar. 5, 2014).

34 The SEC does not have to satisfy all the same elements of a fraudclaim that a private plaintiff must. For example, the agency need notestablish reliance because the agency did not in fact purchase thesecurities at issue. See SEC v. Credit Bancorp, Ltd., 195 F.Supp.2d 475,490-91 (S.D.N.Y.2002) ("The SEC does not need to prove investor reliance,loss causation, or damages in an action under Section 10(b) of theExchange Act, Rule 10b-5, or Section 17(a) of the Securities Act.").

58 COL UMBIA BUSINESS LA W RE VIE W [Vol. 2014

conduct is sufficiently egregious.3 5 In addition to these expost remedies for fraud, federal disclosure requirementsapply to sales of securities ex ante,3 6 and accountants andlawyers act as gatekeepers who are, in theory at least, in aposition to deter, detect, and/or disclose potential fraud.37

Each mechanism has drawbacks. Self-regulatoryorganizations, which monitor the conduct of their ownmembers, face structural conflicts of interest,38 as do lawyersand accountants monitoring the conduct of their clients. TheSEC suffers resource constraints that make it difficult toinvestigate, let alone act upon, every indication suggestingthat a transaction may be fraudulent.3 9 Moreover, while

35 Drawing the line between civil and criminal securities fraud is nostraightforward task. See generally Samuel W. Buell, What Is SecuritiesFraud?, 61 DUKE L.J. 511 (2011) (describing the fundamental difficulty ofdefining securities fraud and the ensuing problems in determining theproper scope of Rule 10b-5).

36 The Exchange Act makes it unlawful for any person to sell asecurity that is not registered with the SEC, unless the security isexempted from the requirement. See 15 U.S.C. § 781(a) (2012). In itsapplication for registration, the issuer must provide various pieces ofinformation, including the "financial structure and nature of the business."See id. § 781(b)(1)(A).

37 Professor Coffee helpfully distinguishes between the gatekeeper asindependent preventer of wrongdoing, and the gatekeeper as agent withan incentive to protect its "reputational capital" by refusing to permitwrongdoing on its watch. See JOHN C. COFFEE, JR., GATEKEEPERS: THE

PROFESSIONS AND CORPORATE GOVERNANCE 2-3 (2006). The gatekeeper ishired by the issuer of securities, so the gatekeeper's incentive to protect itsreputation and prevent improper disclosure, for example, may be intension with its interest in getting paid to complete the deal and in beinghired to advise on subsequent deals. Id. at 4.

38 See, e.g., Jill E. Fisch, Top Cop or Regulatory Flop? The SEC at 75,95 VA. L. REV. 785, 800-01 (2009) (describing FINRA's "obviousshortcomings" in responding to questionable conduct, including researchanalysts' conflicts of interest and the scandal following claims of poordisclosure of the riskiness of auction rate securities).

39 In congressional testimony regarding the SEC's budget, SEC ChairMary Jo White warned that the agency's "current level of resources stillpresents significant challenges as we seek to keep pace with the growingsize and complexity of the securities markets and fulfill our broadmandates and responsibilities." Mary Jo White, Chair, SEC, Testimony onSEC Budget Before the Subcommittee on Financial Services and General

59No. I1:47] HURDLES OF DIFFERENT HEIGHTS

some frauds represent glamorous opportunities forprosecutors seeking career advancement, criminal securitiescases threaten to be long, difficult, and fiercely litigated.4 0

Advocates of tighter restrictions on securities litigationhave consistently argued that the private right of actionachieves none of its goals. First, individual wrongdoers mayface strong incentives, in the form of higher personalcompensation, to engage in fraud yet they are unlikely tosuffer individually from of investor claims,4 1 and so privateinvestor lawsuits do not deter fraud.4 2 Second, for the samereason, individual wrongdoers who perpetrate a fraud do notsuffer meaningful punishment as a result of investorlitigation.4 3 Third, compensation of investors affected by

Government, Committee on Appropriations, U.S. House of Representatives(May 7, 2013), available at http://www.sec.gov/news/testimony/2013/ts05O7l3mjw.htm. In addition, the SEC has been criticized for allowingdefendants charged with fraud to settle claims without admittingwrongdoing, suggesting the existence of some sort of internal constraint onagency action. U.S. District Court Judge Jed S. Rakoff of the SouthernDistrict of New York has blocked such settlements because of the languageregarding acknowledgment of guilt. See Edward Wyatt, Judge Rejects AnS.E.C. Deal With Citigroup, N.Y. TIMES, Nov. 29, 2011, at Al.

40 In addition, in an area subject to multiple sources of regulation, itis possible that the result will be too little enforcement. William W.Buzbee has described this as a challenge of the "regulatory commons," inwhich regulatory resources are not aligned with needs. See William W.Buzbee, The Regulatory Fragmentation Continuum, Westway and theChallenges of Regional Growth, 21 J.L. & POL. 323, 324 (2005). A systemthat relies on fragmented enforcement mechanisms could produceexcessive regulation or insufficient regulation. Yet, "much of thisfragmentation is unavoidable, barring major constitutional restructuringsand discarding America's usual subject-based modes of regulation." Id. at355-58.

41 This is true because individual directors and officers typically enjoyboth the protection of liability insurance and, if necessary and undercertain circumstances, of company indemnification.

42 See John C. Coffee, Jr., Reforming the Securities Class Action: AnEssay on Deterrence and its Implementation, 106 COLUM. L. REV. 1534,1536 (2006) (identifying the "fundamental problem" of securities classaction litigation as the failure either to -compensate victims of fraud ordeter potential wrongdoers).

43 See Helland, supra note 24, at 366.


fraud creates a new set of victims because currentshareholders, who arguably did nothing wrong,4 4 effectivelypay prior shareholders harmed by a past fraud.4 5 Finally,other critics warn that plaintiffs' lawyers have too great anincentive to pursue fraud claims in the interest of obtaininga large fee award, and that the private right of action causestoo much enforcement.4 6 All these criticisms apply toindividual or class action litigation and to claims arising outof purchases on public exchanges or through privateplacements; critics have not drawn distinctions based on thenature of the investment.

B. The Benefits of the Private Right of Action

While critics of investor lawsuits warn of the harm suchlitigation causes issuers of securities, aggrieved investors,like purchasers of any other defective good, have a legitimatedemand for a remedy. Fraud claims also serve an expressivepurpose, condemning conduct that caused harm. Somescholars advance other justifications for investor lawsuits-or at least for shareholder lawsuits-beyond the traditionallist. Professor Lawrence E. Mitchell argues that investorlawsuits improve corporate governance at publicly tradedcompanies because the prospect of paying damages createsan incentive for proper oversight of corporate management.4 7

This rationale applies to lawsuits filed by shareholders, asopposed to claims brought by investors holding other types of

44 Professor Lawrence E. Mitchell disputes this characterization ofcurrent shareholders and argues that because they have power overcorporate and executive conduct, they are not blameless when that conductis wrongful, and they should pay compensation to victims of past fraud.See Lawrence E. Mitchell, The "Innocent Shareholder" An Essay onCompensation and Deterrence in Securities Class-Action Lawsuits, 2009Wis. L. REV. 243, 289-90 (2009).

45 See Coffee, supra note 422, at 1537.46 See, e.g., James J. Park, Rules, Principles, and the Competition to

Enforce the Securities Laws, 100 CAL. L. REV. 115, 121 (2012) (describingcriticisms of decentralized securities law enforcement, which may lead"enforcers to bring more cases than is socially optimal").

47 See Mitchell, supra note 44, at 292.

No. I1:47]1 HURDLES OF DIFFERENT HEIGHTS 61

securities, because those other circumstances would notimplicate corporate governance. The private right of actionmay be more important than ever as a regulatory tool giventhe difficulty of monitoring transactions that have growntremendously in number and complexity.

Deterrence, too, may not be as easily dismissed as criticssuggest. At a minimum, the threat of securities litigationweighs on executives' minds. If it did not, corporate tradegroups would not invest such time and energy in seekingrestrictions on investor lawsuits. There is good reason forthis concern-not because the impact on individualexecutives is likely to be great, as mentioned above, butbecause claims of fraud embody a moral judgment aboutcorporate conduct: investor lawsuits are, again, expressive.Either settlement or, in the exceedingly rare case of alawsuit that goes to trial, a verdict for the plaintiff reinforcesthe impression of improper conduct. The plaintiffs havealleged securities fraud, and fraud has no positiveconnotations. In investing, appearances make a difference. 48

Defendants in fraud cases understand this.Appearances matter in another way: the more difficult

fraud litigation appears to be, the less trusting and, indeed,the more cynical investors will become. Changes to regimesthrough which victims of fraud can recover at least someportion of their damages have implications for markets andfor investor willingness to participate in financial marketsmore generally. Consequently, tougher standards forplaintiffs in securities fraud cases, the subject of Part IV,matter. Despite the criticisms of private securities litigation,fraud constitutes a wrong against investors, and fraudlitigation has potential, positive externalities.

48 John Maynard Keynes famously compared investing toparticipating in a competition to pick not the most beautiful contestant ina beauty contest but the contestant whom other judges would think themost beautiful. JOHN MAYNARD KEYNES, THE GENERAL THEORY OFEMPLOYMENT, INTEREST AND MONEY 156 (1936).



C. The Multiple Paths Permitting Private SecuritiesLitigation

Section 10(b) of the Exchange Act does not provide theonly path to recovery for investors who allege securitiesfraud.49 The existence of alternate means of recovery offersfurther evidence that lawmakers considered privatelitigation an essential component of regulation andenforcement. Section 11 of the Securities Act explicitlypermits an investor to sue if the registration statement50 fora security "contained an untrue statement of a material factor omitted to state a material fact required to be statedtherein or necessary to make the statements therein notmisleading."5 1 Section 12(a)(2) of the Securities Act makesthe seller of a security liable if the seller's prospectuS52

"includes an untrue statement of a material fact or omits tostate a material fact necessary to make the statements, inthe light of the circumstances under which they were made,not misleading."5 3

Neither section 11 nor section 12(a)(2) requires a plaintiffto establish scienter, frequently the stumbling block foroutsider investors in fraud lawsuits under section 10(b).54

Both provisions are available to such investors, but section11 is not available to private placement investors buying

49 When this Article refers to § 10(b), it encompasses Rule 10b-5thereunder. See 17 C.F.R. § 240.10b-5 (2013).

50 A registration statement filed with the SEC is required by § 6 of theSecurities Act, 15 U.S.C. § 77f (2012), and contains such information asthe corporate address, the identities of directors, a description of thebusiness, etc. See id. § 77aa.

51 See id. § 77k(a).52 A prospectus is "any prospectus, notice, circular, advertisement,

letter, or communication, written or by radio or television, which offersany security for sale." See id. § 77b(a)(10).

53 See id. § 771(a)(2). The provision goes on to provide for anaffirmative defense for the seller, if the seller can show that "he did notknow, and in the exercise of reasonable care could not have known, of suchuntruth or omission." Id. This is one way that the private right of actionunder § 11 differs from that under § 12.

54 See Part IV infra.

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unregistered securities. The Supreme Court has limited theability of investors in private placements to sue undersection 12(a)(2); a majority of the Court concluded inGustafson v. Alloyd Co., Inc. that the statute only permittedclaims alleging an omission or misstatement in prospectuses"related to public offerings by an issuer or its controllingshareholders."55 Thus, in the wake of Gustafson, investors inprivate placements may be limited to claims under section10(b).56

The focus of this Article is claims under section 10(b),"which are available to both connected and outsider investors.Both connected and outsider investor plaintiffs rely onsection 10(b). Thus, the discussion in Part IV, whichdescribes the disparate effects of pleading standards ondifferent types of plaintiffs alleging fraud, compares cases58

55 Gustafson v. Alloyd Co., Inc., 513 U.S. 561, 569 (1995). Dependingon the meaning of Gustafson, an investor who purchased through a privateplacement under SEC Rule 504 or 505 may be able to sue relying on §12(a)(2) and need not establish scienter, but an investor who purchasedunder Rule 506 may not be able to rely on section 12(a)(2) and thus facesthe challenge of establishing scienter. See DONNA M. NAGY, RICHARD W.PAINTER & MARGARET V. SACHS, SECURITIES LITIGATION AND ENFORCEMENT:CASES AND MATERIALS 317 (3d ed. 2011). These differences exist becauseRules 504 and 505 rely on § 3 of the Securities Act, while Rule 506 relieson § 4. Id. at 4-5, 317.

56 See Christie L. Gamble, Gustafson v. Alloyd: Setting Limits on aPotentially Powerful Weapon, 21 DEL. J. CORP. L. 489, 522 (1996). See alsoNatasha S. Guinan, Note, Nearly a Decade Later: Revisiting Gustafsonand the Status of Section 12(a)(2) Liability in the Courts-Creative JudicialDevelopments and a Proposal for Reform, 72 FORDHAM L. REv. 1053, 1053(2004) (observing that the Gustafson opinion left to lower courts the taskof determining whether a securities offering was private and "thereforeimmune from Section 12(a)(2) liability").

57 Plaintiffs can sue based on violations of multiple provisions, citingboth § 10(b) and § 11 or § 12(a)(2). See Herman & MacLean v. Huddleston,459 U.S. 375, 382-83 (1983) ("[W]e see no reason to carve out an exceptionto Section 10(b) for fraud occurring in a registration statement justbecause the same conduct may also be actionable under Section 11").

58 This comparison may seem arbitrary, because shareholders whopurchase through an IPO have the option of suing based on § 11 or on §10(b). Thus, the argument might be made that § 10(b) plaintiffs have anadvantage over private placement investor plaintiffs, mitigating any


filed by insider investors and suits filed by outsiderinvestors.59 In either case, as discussed below, the privateplacement investor typically has access to transaction-specific information beyond what an outsider investorreceives through registration materials or through publiccompanies' periodic reports to regulators.

One response to the arguments below could be thatinvestors in IPOs have litigation options not available toinvestors in private placements.60 Perhaps the pleadingstandards correctly treat different types of investorsdifferently. The question becomes, are differences in theform of investment relevant to the determination ofeligibility for recovery through litigation? 61 This Articlesuggests that how investors purchased securities should notdetermine the relative ease of ex post fraud litigation.62

unfairness. However, as discussed infra in Part III, the informationcontained in the registration statement is unlikely to enable § 11 claimsrelated to the financial crisis, for example, because unlike the informationprovided to private placement participants, the registration materialsdescribe the company, not specific transactions it engages in. When theunderlying facts are the same or similar and preclude a § 11 claim, thepleading standards applicable to § 10(b) claims favor private placementinvestor plaintiffs.

59 Investors who purchased shares in an IPO can also use § 11 of theSecurities Act if the registration statement included materialmisstatements or omissions. However, in the realm of § 10(b), this Articlecontends that the pleading standards (described in Part III infra) favorprivate placement investors.

60 See supra notes 57 and 55 and accompanying text.61 Perhaps, for example, the different pleading standards are

intended to reward the investors' due diligence in private placements;outsider investors may not perform such due diligence because they relyon the wisdom of a highly liquid financial market. If so, though, thereliance requirement discussed below should function to screen out thoseconnected investors who did not in fact conduct due diligence. This pointhas received greater recognition of late. See, e.g., Floyd Norris, When aDeal Goes Bad, Blame the Ratings, N.Y. TIMES, Nov. 15, 2013, at B1(describing in derisive terms the arguments of securities fraud claimantsthat admitted that they conducted low levels of due diligence beforeentering transactions that produced extremely poor results).

62 A related issue is this Article's treatment of initial purchasers andsecondary market purchasers of securities together: perhaps the

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III. THE PATH TO RECOVERY THROUGH SECTION10(B) SECURITIES LITIGATION

Congress did not explicitly set out to create two differentlegal regimes for plaintiffs alleging a federal securities lawviolation. Rather, decisions by federal legislators seeking toerect hurdles to what they described as frivolous shareholderclass action litigation had the effect of putting differentobstacles, of different sizes, in the path of different types ofclaims. Given Congress' concern with shareholder classactions,63 it is not surprising that lawmakers enacted aregime that hampers shareholder claims. However, thepleading standards do not apply only to class actions or toshareholder lawsuits. The requirements apply to all investorclaims and claimants alleging securities fraud.

This Part takes the first step of demonstrating ways inwhich treatment of a fraud claim brought by outsiderinvestors differs from treatment of a fraud claim brought byconnected investors in securities in private transactions. Itdoes so by summarizing the legal standards applicable toclaims of securities fraud when plaintiffs face a motion todismiss. These standards are the product of legislation andjudicial interpretation.6 4 The first section of this Part

information disparity that advantages connected investors does not existfor secondary market purchasers, whether those purchases took placethrough publicly accessible or private transactions. To respond to thisquestion, I intend to disaggregate the cases reviewed for this Article, inorder to compare the types of evidence used by claimants under § 10(b)filed by initial connected investors and initial outsider investors.

63 See S. REP. NO. 104-98, at 10 (1995), reprinted in 1995 U.S.C.C.A.N.679, 689 (describing the PSLRA as a legislative response to "extensivetestimony concerning certain areas of abuse involving class actions"alleging securities fraud).

64 For purposes of this Article, the Securities Litigation UniformStandards Act of 1998, Pub. L. 105-353, 112 Stat. 3227 (codified inscattered sections of 15 U.S.C.) ("SLUSA") is not relevant. SLUSA barsshareholders from filing securities fraud class action suits in state court orunder state law in federal court and thereby sidestepping therequirements of the PSLRA. See 15 U.S.C. § 78bb (2012). This legislationdid not affect the pleading standards set by the PSLRA, nor did itexplicitly favor particular kinds of plaintiffs, id., although at least one

describes the standards applicable to fraud claims allegingviolations of section 10(b) of the Exchange Act," thenexplores the Supreme Court's elaboration of the particular

scholar has found that federal courts are not consistent in applyingSLUSA, and some jurisdictions are possibly more favorable to certaintypes of litigants. See John M. Wunderlich, "Uniform" Standards forSecurities Class Actions, 80 TENN. L. REV. 167, 196 (2012). SLUSA alsodid not bar filing of fraud claims in state court by individual plaintiffs notseeking certification as a class. See 143 CONG. REC. S10475 (daily ed. Oct.7, 1997) (statement of Sen. Phil Gramm) (noting that SLUSA is limited to"the case of class-action suits, and class-action suits only"). Consequently,a number of post-crisis lawsuits have been filed in state court.

65 The PSLRA amended the Exchange Act. Plaintiffs may sue underother laws, which have different pleading requirements. Plaintiffsalleging that the seller of a financial transaction should be liable fordamages-but did not necessarily engage in fraud-may base a claim oneither a misstatement or omission in a registration statement, seeSecurities Act of 1933 § 11, 15 U.S.C. § 77k, or in a prospectus or oralcommunication connected to a sale. 15 U.S.C. § 771. The misstatement oromission must involve information that would have been material to theplaintiff when weighing whether to invest. Under § 11, an investor maysue a specified set of entities if a registration statement "contained anuntrue statement of a material fact or omitted to state a material factrequired to be stated therein or necessary to make the statements thereinnot misleading." See id. § 77k. Courts have determined that a "material"misrepresentation or omission is one that, in context, would have misled areasonable investor. In re Morgan Stanley Info. Fund Sec. Litig., 592 F.3d347, 360 (2d Cir. 2010). Unlike a claim alleging a violation of Rule 10b-5,a claim under the Securities Act "need allege neither scienter, reliance orloss causation." City of Ann Arbor Emps.' Ret. Sys. v. Citigroup Mortg.Loan Trust, No. CV 08-1418, 2010 WL 6617866, at *6 (E.D.N.Y. Dec. 23,2010) (noting the difference in requirements of Exchange Act andSecurities Act claims and denying defendants' motion to dismiss claimsasserting violations of §§ 11, 12(a)(2), and 15 of the Securities Act). Aclaim alleging a violation of the Securities Act is narrower than a § 10(b)claim in that it focuses on a particular security described in a registrationstatement or prospectus. In contrast, a plaintiff suing under § 10(b) mayallege a "broader course of conduct." Emps.' Ret. Sys. v. J.P. MorganChase & Co., 804 F. Supp. 2d 141, 150 (S.D.N.Y. 2011) (contrasting causesof action under § 10(b), which "allows a plaintiff to claim that it washarmed by fraudulent representations that are 'connected to' a securitythat the plaintiff purchased or sold," and causes of action under § 11,which applies if a "specific registration statement contain[ed]misrepresentations," or under § 12, which applies if a "specific prospectusor oral communication" contained misrepresentations).

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elements of a securities fraud claim-scienter, reliance, andloss causation-that are often at issue at the time ofdisposition of a motion to dismiss. The second sectiondescribes the heightened pleading standard applicable toallegations of fraud under the Federal Rules of CivilProcedure. The third section then describes the impact ofthe PSLRA.

Understanding the requirements of federal securitiesfraud claims requires diving into a complicated and evolvingarea of jurisprudence. This understanding is essential todetermining how changes in pleading standards have theeffect of easing the path to recovery for connected investorsrelative to outsider investors. This more favorable treatmentof particular claimants, as contended below, is consistentwith predictions of past scholarship on the advantages heldby potential litigants who are repeat players and whoconsequently have the ability to mold legal regimes overtime. This shaping can occur through case outcomes or, as inthe case of the PSLRA, through legislative advocacy.

A. The Elements of a Claim of Fraud Under theExchange Act

The Exchange Act prohibits the "use or employ[ment], inconnection with the purchase or sale of any securityregistered on a national securities exchange or any securitynot so registered . .. [of] any manipulative or deceptivedevice or contrivance in contravention of such rules andregulations as the [SEC] may prescribe.""6 The courts foryears have recognized a private right of action for violation ofthis provision of the Act, and the Supreme Court hasidentified six elements of a fraud claim under section 10(b)and its implementing regulation, Rule 10b-5: (1) a materialrepresentation or omission by the defendant; (2) scienter; (3)a connection between the misrepresentation or omission andthe purchase or sale of a security; (4) reliance upon the

66 15 U.S.C. § 78j(b). The provision is implemented through Rule 10b-5, 17 C.F.R. § 240.10b-5 (2013), which does not add detail to the law.



misrepresentation or omission; (5) economic loss; and (6) losscausation.6 7

The meaning of each of the above elements has been thesubject of litigation,6 but clarity has remained elusive, inpart because of the highly context-dependent nature of anyinquiry into fraud.

Securities fraud lawsuits filed following the 2008financial crisis often turned on only a subset of the elementsidentified above. A review of dozens of securities fraud casesfiled in state and federal courts found that resolutions ofmotions to dismiss focused generally on scienter, reliance,

67 See Erica P. John Fund, Inc. v. Halliburton Co., 131 S. Ct. 2179,2184 (2011) (quoting Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct.1309, 1317 (2011)).

68 See, e.g., Matrixx Initiatives, 131 S. Ct. at 1318-19 (explaining thatmateriality of information does not depend on statistical significance orother "bright-line rule," but on the "'total mix' of information madeavailable" (quoting Basic Inc. v. Levinson, 485 U.S. 224, 232 (1988)));Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 309 (2007)(deciding that "an inference of scienter must be more than merelyplausible or reasonable-it must be cogent and at least as compelling asany opposing inference of nonfraudulent intent"); Basic, 485 U.S. at 246(finding that merger discussions were material to reasonable investors andthat investors' reliance could be established by their assumption thatmarket prices reflected all publicly available information and "hence, anymaterial misrepresentations"); Dura Pharm., Inc. v. Broudo, 544 U.S. 336,342-43 (2005) (rejecting the argument that payment of an inflated price atthe time of purchase as a result of a misrepresentation constitutedeconomic loss); Erica P. John Fund, 131 S. Ct. at 2183, (plaintiff seekingcertification of a class in a securities fraud action need not prove losscausation). While in Erica P. John Fund the Court stated that a plaintiffneed not prove loss causation, the justices reached this conclusion onlyafter an intriguing detour in the unanimous opinion concerning reliance.The Court distinguished between "transaction causation" and "losscausation": the former referred to reliance on a misrepresentation "whenbuying or selling" and the latter to proof of economic loss as a result of themisrepresentation (or correction of the misrepresentation, as was alleged).Id. at 2186. "[Wlhen considering whether a plaintiff has relied on amisrepresentation, we have typically focused on facts surrounding theinvestor's decision to engage in the transaction," id., and this tantalizingobservation raises the question of whether the Court is preparing toaddress questions posed in this Article about what level of diligence is dueand what it means to be sophisticated.

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and loss causation. The other elements appear less often assources of controversy. With respect to materiality, in post-financial crisis litigation it is often clear that informationabout massive exposure to, or the magnitude of lossesresulting from, home loan defaults would be material toreasonable investors.6 9 The connection to the purchase orsale of a security is typically clear. In the absence ofeconomic losses, a lawsuit would likely not have been filed inthe first place. Below I very briefly describe how scienter,reliance, and loss causation are critical and summarize howthe Supreme Court has analyzed them.

1. Scienter

To allege that a defendant acted with scienter, a plaintiffmust assert facts that reveal an intent to "'deceive,manipulate, or defraud."'7 O The Supreme Court hasinterpreted the language of the PSLRA, which requires a"strong inference" of scienter71 to mean that the inferencemust be "cogent and at least as compelling as any opposinginference one could draw from the facts alleged."7 2 Thus,courts must consider innocent explanations of the allegedconduct. In the Second Circuit, showing "reckless

69 See, e.g., In re Bear Stearns Cos., Inc. Sec., Derivative, & ERISALitig., 763 F. Supp.2d 423, 488-89 (S.D.N.Y. 2011) (finding thatdefendants' alleged failure to disclose that they had "inflated their assetvalues while underestimating their risk . . . [was] properly alleged to be

significant to the reasonable investor making an investment decision"). Ofcourse, defendants may contend in some cases that the informationallegedly concealed or mischaracterized was not certain or significantenough to make a failure to disclose material. See, e.g., Richman v.Goldman Sachs Grp., Inc., 868 F. Supp.2d 261, 274 (S.D.N.Y. 2012)(dismissing shareholders' § 10(b) claims against investment bank becausedefendant was not under obligation to disclose receipt of Wells notice giventhat litigation was not "substantially certain to occur").

70 Tellabs, 551 U.S. at 313.71 15 U.S.C. § 78u-4(b)(2)(A).72 Tellabs, 551 U.S. at 324.73 Id. at 323-24.

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disregard for the truth"7 4 can satisfy the scienterrequirement.

The PSLRA complicates this story, though, because itadds a "safe harbor" protecting a speaker making certainstatements from liability in any private litigation based onan allegation that the speaker made an untrue statement ofa material fact or failed to state a material fact necessary tomake a statement not misleading." The law protects"forward-looking statements," meaning those statementsthat, for example, provide a projection of revenues, income,or loss, or other financial items; or that describe businessplans and objectives. When an investor argues that adefendant committed fraud by making a materially false,forward-looking statement, the scienter requirement ismore demanding. The plaintiff must prove that the forward-looking statement was made "with actual knowledge ... thatthe statement was false or misleading."7 This showing ofactual knowledge must be made in accord with the PSLRA'srequirement that the plaintiff "state with particularity factsgiving rise to a strong inference that the defendant actedwith the required state of mind."7 This inquiry can becomplex.8 0

74 S. Cherry St., LLC v. Hennessee Grp. LLC, 573 F.3d 98, 109 (2dCir. 2009).

75 See 15 U.S.C. § 77z-2(c).76 See id. § 77z-2(i)(1). The provision identifies several other types of

information that might constitute a "forward-looking statement," such asprojection of capital expenditures, dividends, earnings or losses per share,descriptions of product or service offerings or objectives, etc.

77 Or omitting a statement necessary to make a statement notmisleading.

78 15 U.S.C. § 77z-2(c)(1)(B)(i).79 See id. § 78u-4(b)(2)(A).s0 See, e.g., Makor Issues & Rights, Ltd. v. Tellabs Inc., 513 F.3d 702,

709 (7th Cir. 2008) (discussing relationship of the PSLRA safe harbor tothe law's pleading requirements but reframing the "critical question . . .[as], how likely it is that the allegedly false statements ... were the resultof merely careless mistakes . . . rather than of an intent to deceive or a

reckless indifference to whether the statements were misleading" ratherthan whether the speaker had "actual knowledge" of falsity).

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2. Reliance

The reliance element can be disaggregated. First, there isthe question of actual reliance. Second, there is the questionof whether the investor's reliance on the allegedly fraudulentstatement or omission was reasonable. In the securitiesfraud class action lawsuits that have reached the SupremeCourt, the justices have addressed actual reliance.8' In casesin lower courts, in particular in cases filed since the financialcrisis of 2008, judges have grappled with the reasonablenessof alleged reliance.8 2 The focus in this Article is onreasonable reliance.

The reasonableness of reliance plays a significant role inpost-crisis litigation initiated by investors who purchased inprivate placements. Such plaintiffs typically claim that theydecided to invest because they believed misleading or falseinformation about a transaction provided by thedefendants.8 3 Defendants in turn challenge plaintiffs'

81 See, e.g., Basic Inc. v. Levinson, 485 U.S. 224, 246 (1988) (discussinghow actual reliance may be established).

82 One reason for this difference is the availability of a presumption infavor of shareholders of actual and reasonable reliance on legallymandated disclosures by issuers, if the shareholders bought intransactions on public secondary markets or through public offerings. SeeBasic, 485 U.S. at 250; see also 15 U.S.C. § 77z-2. Purchasers throughprivate placement transactions can attempt to take advantage of thepresumption and even succeed, but still then must establish that theirreliance was reasonable.

83 This discussion focuses on allegations of reliance on specificstatements or omissions by a selling financial institution. There are otherways to allege reliance under federal law. However, (a) they do not figurein the financial institution-on-financial institution litigation which is theprimary subject of this Article; (b) in such other cases the analysis of aplaintiffs asserted reliance turns not on the conduct of the investor but onthe characteristics of the market-whether the market was sufficientlyopen and developed that prices reflected publicly available informationand material misrepresentations, such that reliance on market prices wassufficient to establish reliance on the misrepresentation and enable a §10(b) claim, as the Supreme Court permitted in Basic, 485 U.S. at 244(noting that "[iun an open and developed market, the dissemination ofmaterial misrepresentations or withholding of material informationtypically affects the price of the stock"); or (c) the central issue is the

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assertions of victimhood by pointing out that (a) prior to thetransaction, the plaintiffs held themselves out assophisticated investors fully capable of evaluating risks, 84

and (b) information available to the sophisticated investormade plain what those risks were."5 In many cases,investing financial institutions explicitly acknowledged,before entering into the transaction, that they were notrelying on any representations made by the seller, that the

proximity of allegedly fraudulent conduct to the transaction that theplaintiff entered. See Stoneridge Inv. Partners, LLC v. Scientific-Atlanta,Inc., 552 U.S. 148, 159 (2008) (deciding that vendors' role in defendant'sfraudulent scheme to inflate reported earnings was "too remote" to makethem liable in civil action under § 10(b)). Some scholars have questionedcourts' use of the fraud on the market theory to satisfy the relianceelement of a claim. See, e.g., Roberta S. Karmel, When Should InvestorReliance Be Presumed in Securities Class Actions?, 63 Bus. LAw. 25, 53(2007) (calling for, among other things, "apply[ing] the presumption ofreliance narrowly to false or misleading statements in filed documentsmade by issuers").

84 For example, in Dandong v. Pinnacle Performance Ltd., No. 10 Civ.8086(LBS), 2011 WL 5170293, at *13-14 (S.D.N.Y. Oct. 31, 2011), inwhich the defendants argued that their motion to dismiss should begranted because they had "disclosed the risks . . . and that by accepting

those warnings, Plaintiffs held themselves out to be sophisticatedinvestors," the court determined that the reasonableness of relianceturned on facts and so was not amenable to resolution on a motion todismiss. But see Terra Sec. ASA Konkursbo v. Citigroup, Inc., 740 F.Supp. 2d 441, 453 (S.D.N.Y. 2010) (finding that two plaintiffs weresufficiently sophisticated that their reliance on defendants'characterization of a transaction was "unreasonable as a matter of law").

85 See, e.g., CIFG Assurance N. Am., Inc. v. Goldman, Sachs & Co.,No. 652286/2011, 2012 WL 1562718, at *15 (N.Y. Sup. Ct. May 1, 2012)(noting that the defendants obtained dismissal of fraud claims afterarguing plaintiff, a sophisticated investor, could not establish reasonablereliance after failing to "review [the defendant's] underwriting guidelinesor any of [the defendant's] underlying loans").

86 For example, in ACA Fin. Guar. Corp. v. Goldman, Sachs & Co.,No. 650027/2011, 2012 WL 1425264, at *9 (N.Y. Sup. Ct. Apr. 23, 2012),the defendant argued that "ACA cannot reasonably have relied on analleged misrepresentation when a signed contract disclaims reliance." Thetrial court rejected this argument because the disclaimers were"boilerplate" and did "not go to the specific misrepresentation alleged . . . ."Id. at 10. But see San Diego Cnty. Emps. Ret. Ass'n v. Maounis, 749 F.

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transaction was conducted at arms' length, and that theyhad the capacity to assess the riskiness of the transaction.As a result, defendants argue, the plaintiff investor cannotreasonably claim to have been the victim of any fraudulentstatement or omission by the selling institution.88

The determination of reasonableness, then, is critical. Itis highly contextual and turns on several factors, including:(1) the sophistication and expertise of the plaintiff infinancial and securities matters; (2) the existence oflongstanding business or personal relationships; (3) access tothe relevant information; (4) the existence of a fiduciaryrelationship; (5) concealment of the fraud; (6) theopportunity to detect the fraud; (7) whether the plaintiffinitiated the stock transaction or sought to expedite thetransaction; and (8) the generality or specificity of themisrepresentations.8

No single factor is decisive and there is no precisedefinition of a sophisticated investor; that, too, may dependon context.90 However, a plaintiffs degree of sophistication

Supp. 2d 104, 121 (S.D.N.Y. 2010) (granting motion to dismiss afterfinding that in light of the sophistication of the plaintiff retirementinvestment fund "and the clear, unambiguous language of the non-relianceprovisions," the plaintiffs "purported reliance ... [was] unreasonable").

87 See, e.g., MBIA Ins. Corp. v. Royal Bank of Can., No. 12238/09,2010 WL 3294302, at *33 (N.Y. Sup. Ct. Aug. 19, 2010) (describing suchdisclaimers but ultimately concluding that they did not preclude plaintiffsfraud claim).

88 In such a case, reliance would not be reasonable. See Zobrist v.Coal-X, Inc., 708 F.2d 1511, 1518 (10th Cir. 1983) (private placementpurchasers of ownership interest in the defendant company sued under §10(b) alleging misrepresentations and omissions regarding the company'sprospects and court found for the defendant because the plaintiff investorsdid not read warnings in the private placement memorandum and so didnot reasonably rely on any allegedly fraudulent statement).

89 Owens v. Gaffken & Barriger Fund, LLC, No. 08 Civ. 8414 (PKC),2011 WL 1795310, at *3 (S.D.N.Y. May 5, 2011) (citing Brown v. E.F.Hutton Grp., Inc., 991 F.2d 1020, 1032 (2d Cir. 1993)).

90 For example, in denying the defendants' motion for summaryjudgment in Owens, Judge P. Kevin Castel concluded that a "reasonablejuror could conclude either that Owens was reasonable or unreasonable inrelying solely on uncontradicted oral statements" by the defendants.



affects how courts weigh the other criteria. For example, themore sophisticated the investor, the more likely a judge is toask why that investor did not ask for access to relevantinformation.91 A judge might expect a sophisticated investorto detect signs of fraud more easily. 92 Courts do not makeexplicit the relationship between an analysis of thereasonableness of reliance and of a buyer's obligation toconduct due diligence. 9 3

Only an investor who has adequately studied atransaction ahead of time may be permitted by law to pursuea fraud claim.94 However, even a sophisticated investor whohas taken appropriate precautions can be fooled. Both

Because of the dispute over this material fact, the judge denied themotion. Id. at *5.

91 See, e.g., Ashland Inc. v. Morgan Stanley & Co., Inc., 700 F. Supp.2d 453, 471 (S.D.N.Y. 2010) (granting motion to dismiss in part because"[a]s a sophisticated institution contemplating the investment of tens ofmillions of dollars, it was unreasonable for [plaintiff] to rely upon thehighly general statements alleged as misstatements in this case . . . [and]perhaps reckless . . . to not insist upon receiving, in writing . . . and termsof purchase before making its initial investment").

92 See Terra Sec. ASA Konkursbo v. Citigroup, Inc., 740 F. Supp. 2d441, 449 n.5, 453 (S.D.N.Y. 2010) (determining that municipal plaintiffsare "not sophisticated investors for the purposes of this inquiry," and thusdenying defendant's motion to dismiss, but granting the motion for claimsbrought by sophisticated investors).

93 In an article that foreshadows the argument made below in thisArticle, Professor Margaret V. Sachs wrote that the Supreme Court has atleast implicitly suggested that common law tort doctrines imported intosecurities law may be subordinated to public policy goals. Therefore,fraudsters should not be able to escape civil liability even if they can showplaintiffs failed to take due care. See Margaret V. Sachs, The Relevance ofTort Law Doctrines to Rule 10b-5: Should Careless Plaintiffs Be DeniedRecovery?, 71 CORNELL L. REV. 96, 137 (1985). In fact, she suggestedabandoning the requirement that a plaintiff show that due care was takenbefore investing. See id. at 140.

94 See, e.g., Hirsch v. DuPont, 553 F. 2d 750, 763 (2d Cir. 1977) ("Thesecurities laws were not enacted to protect sophisticated businessmenfrom their own errors of judgment [and s]uch investors must, if they wishto recover under federal law, investigate the information available to themwith the care and prudence expected from people blessed with full accessto information.").

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federal and state courts have recognized that if informationthat would have enabled the plaintiff to detect the fraud was"within the peculiar knowledge of [d]efendants andunavailable to" plaintiffs,95 then the plaintiffs claimedreliance may have been reasonable.9 6 However, if judges aretoo generous to plaintiffs making this claim, then therequirement that reliance be reasonable becomes weaker.Investors may then do less to protect themselves throughdue diligence, because the allocation of risk of losses willhave shifted in their favor.97 This concern drives theargument below that the standard applicable to claims ofreasonable reliance should be refined. The harm suffered byan investor plaintiff could have two causes: misconduct ofthe defendant and/or negligence of the plaintiff.9 8 In the

95 Terra Sec., 740 F. Supp. 2d at 449.96 See, e.g., SRM Global Fund L.P. v. Countrywide Fin. Corp., 2010

WL 2473595, at *13-14 (S.D.N.Y. June 17, 2010) (granting defendants'motion to dismiss after finding that information indicative of the riskinessof the transaction was available prior to plaintiffs' investment). TheSupreme Court has clearly limited who may be liable under suchcircumstances. See Stoneridge Inv. Partners LLC v. Scientific-Atlanta,Inc., 552 U.S. 148, 152 (2008), (determining that investors could notpursue claims against vendors and suppliers who allegedly participated infraudulent misstatement of the defendant corporation's financial results).See also, Cent. Bank of Denver, N.A. v. First Interstate Bank of Denver,N.A., 511 U.S. 164 (1994), (barring private rights of action against aidersand abettors of securities fraud).

97 In a pre-PSLRA article examining the implications of the conduct ofplaintiff investors for 10b-5 claims, Theresa A. Gabaldon argued that itwas unlikely that the possibility of recovery through litigation would affectinvestment decisions. See Theresa A. Gabaldon, Unclean Hands and Self-Inflicted Wounds: The Significance of Plaintiff Conduct in Actions forMisrepresentation Under Rule 10b-5, 71 MINN. L. REV. 317, 342 (1986) ("Itis unlikely . . . that a plaintiff would make what is probably a bad

investment in the hope of eventually receiving damages throughlitigation."). However, I contend that it is rather more likely that aninvestor would refrain from making a bad investment if the likelihood ofrecovery through litigation becomes more remote, and fewer badinvestments reduces the likelihood of systemic crises.

98 If the defendant essentially argues that the plaintiff would havesuffered losses regardless of the defendant's conduct, that counterfactualneed not bar recovery. See Mark P. Gergen, Causation in Disgorgement,

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context of securities fraud, decisions about what degree ofreliance is reasonable matter because they may affect theconduct of parties to future transactions. Judicialevaluations of other elements of a claim of fraud do not havethe same potential incentive effects."

3. Loss causation

Establishing that the alleged fraud actually caused aplaintiffs losses can be difficult because so many events canaffect the price of an investment. The inquiry must be fact-intensive. A judge might consequently deny a motion todismiss because determining the extent to which a plaintiffslosses resulted from a defendant's conduct requires a carefulanalysis of facts and the factual record might not besufficiently developed. When seeking to survive a motion to

92 B.U. L. REV. 827, 837 (2012). The competing causes of harm need notmean that wrongdoing goes unpunished and/or a victim recovers nothing.Rather, "they show the normative importance of deciding what is apermissible counterfactual." Id.

99 For example, accepting a particular showing of scienter does notimplicate the level or kind of diligence an investor should perform beforedeciding whether to participate in a transaction. In addition, financialinstitutions in many cases already have e-mail messages or otherdocumentary evidence enabling them to establish "a strong inference thatthe defendant acted with the required state of mind." 15 U.S.C. § 78u-4(b)(2)(A) (2012). Loss causation, discussed below, similarly does notrelate to the question of the adequacy of a plaintiffs due diligence and inany event is likely to raise problems for a plaintiff at a later stage inproceedings; a defendant may argue that the plaintiffs losses were theresult of a general market downturn, for example, or some other eventunrelated to the defendant's conduct. See, e.g., Dodona I, LLC v. Goldman,Sachs & Co., 847 F. Supp. 2d 624, 649 (S.D.N.Y. 2012) (denying motion todismiss despite defendant's argument that plaintiffs losses "coincidedwith the general market downturn and therefore cannot be linked with thealleged fraud, [because] the law does not require plaintiffs to plead factssufficient to exclude other non-fraud explanations. . . . [T]hat is an issue tobe determined by the trier of fact on a fully developed record" (citationsomitted)). The parties then contest the allocation of blame for lossesamong competing causes. That action is likely to raise questions of factnot suitable for resolution on a motion to dismiss. See King Cnty., Wash.v. IKB Deutsche Industriebank AG, 708 F. Supp. 2d 334, 342 (S.D.N.Y.2010).

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dismiss, the plaintiff need not allege facts that "'excludeother non-fraud explanations."'100 It may be that at a laterstage, a court would have to wrestle with the apportionmentof losses to various causes. A general market downturnmight have pushed prices downward, but misconductparticular to a defendant might have pushed the value of aparticular transaction down even more. 1 However,establishing the link between alleged fraud and economiclosses in the context of a more general negative economicevent may be complicated for any securities fraud plaintiff,whether an investor who bought through a publiclyaccessible transaction, or a participant in a privateplacement. For this reason, this Article will not discuss losscausation further. 102

B. The Federal Rules of Civil Procedure

Courts explaining the Exchange Act have identified theelements of a claim of securities fraud under federal law.Rule 9(b) of the Federal Rules of Civil Procedure thenspecifies the pleading standard that such claims must meet.The rule requires the plaintiff to "state with particularity the

100 IKB Deutsche Industriebank AG, 708 F. Supp. 2d at 342.101 For example, in Dodona I, Judge Victor Marrero held that it was

inappropriate to determine the cause of the plaintiffs losses whenresolving a motion to dismiss. Judge Marrero cited prior cases statingthat determination of causation was "an issue to be determined by thetrier of fact on a fully developed record." Dodona I, 847 F. Supp. 2d at 649(quoting In re Bear Stearns Cos., Inc. Sec., Derivative, & ERISA Litig., 763F. Supp. 2d 423, 507 (S.D.N.Y. 2011)). Because the plaintiff successfullypleaded the other elements of a securities fraud claim under § 10(b), JudgeMarrero denied the defendant's motion to dismiss. Id. at 650.

102 Courts may actually blur the distinction between reliance and losscausation, however. See Jill E. Fisch, Cause for Concern: Causation andFederal Securities Fraud, 94 IOwA L. REV. 811, 825-26 (2009) (describingsome courts' decision to analyze together reliance and loss causation,requiring plaintiffs to show loss causation in order to establish reliance, insecurities class actions in which plaintiffs use a theory of fraud on themarket).

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circumstances constituting fraud or mistake."1 0 3 Federalcourts in New York have interpreted the requirement of"particularity" to mean that a plaintiff must "(1) specify thestatements that the plaintiff contends were fraudulent, (2)identify the speaker, (3) state where and when thestatements were made, and (4) explain why the statementswere fraudulent."1 0 4 The plaintiff need not allege reliance ondirect communications from the defendant, nor specify whorelied on such communications. 105 In actions initiated byconnected investors, these four requirements generally donot pose as much of a hurdle as they do for outsiderinvestors. Private transactions are preceded bypresentations, meetings, and exchanges of transaction-specific e-mail, prospectuses, offering memoranda, and otherdocuments.10 6

C. The PSLRA

Lawmakers in the 1990s concluded that Rule 9(b) was notan adequate device for blocking meritless claims of securities

103 FED. R. Civ. P. 9(b). This heightened standard does not apply toallegations of "[m]alice, intent, knowledge, and other conditions of aperson's mind," which remain subject to the general pleading standard ofRule 8. See Ashcroft v. Iqbal, 556 U.S. 662, 686 (2009). Rule 8 requires a"short and plain statement of the claim showing that the pleader isentitled to relief," FED. R. Civ. P. 8(a)(2), which the Court stated meansthat "a complaint must contain sufficient factual matter, accepted as true .. . [to] allow[] the court to draw the reasonable inference that thedefendant is liable for the misconduct alleged." Id. at 678.

104 Rombach v. Chang, 355 F.3d 164, 170 (2d Cir. 2004) (citationomitted).

105 See Terra Sec. ASA Konkursbo v. Citigroup, Inc., 740 F. Supp. 2d441, 441 (S.D.N.Y. 2010).

106 Investors who purchased securities through private placementsenjoy access to a different level of information, relative to investorspurchasing publicly traded instruments on public exchanges.Shareholders alleging fraud must generally rely on public statements bycorporate executives and corporate filings with regulators, and thosestatements may describe corporate activities but of necessity do so inabbreviated fashion. Offering memoranda and other documents providedbefore a private placement offer specific information about thecharacteristics of that deal. See infra Part IV.A.

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fraud. In enacting the PSLRA, they raised the bar forspecific elements of the claim, thereby adjusting how the lawbalanced the competing goals of allowing "defraudedinvestors . . . [to] recover their losses,"107 on the one hand,and blocking "abusive and meritless" claims on the other.10 8

Fear of the effects of shareholder litigation on the conduct ofbusiness animated members of Congress.109 Lawmakersworried that "strike suits"-claims filed upon a company'sannouncement of bad news sufficient to affect stock prices-were sapping potentially productive corporate resourcessolely to line the pockets of lawyers representing classes ofshareholders.110 With the PSLRA, Congress sought to

107 H.R. REP. No. 104-369, at 31 (1995) (Conf. Rep.), reprinted in 1995U.S.C.C.A.N. 730, 730. For a more complete discussion of the filtering roleplayed by the pleading standards applicable to claims under federalsecurities laws, see Geoffrey Miller, A Modest Proposal for SecuritiesFraud Pleading After Tellabs, 75 LAw & CONTEMP. PROBS. 93, 93, 104-05(2012). See also James D. Cox, Randall S. Thomas & Lynn Bai, DoDifferences in Pleading Standards Cause Forum Shopping in SecuritiesClass Actions?: Doctrinal and Empirical Analyses, 2009 Wis. L. REV. 421,451-52 (suggesting that Tellabs was a "missed opportunity ... to bringuniformity into the interpretation of the PSLRA" and finding thatdifferences in pleading requirements across jurisdictions did not result inforum shopping by plaintiffs, but also did not address the question ofwhether the standards deterred some claimants in certain jurisdictionsfrom filing class action suits).

108 H.R. REP. No. 104-369, at 31. Whether there was a crisis of"frivolous" securities litigation at the time of passage of the PSLRA--orindeed in the years since-has been the subject of scholarship and politicaldebate. For a critique of the language used by supporters of restrictionson securities litigation, see Miller, supra note 107, at 98-99; for moredetailed analysis of whether companies settle securities lawsuitsregardless of the merits, see Stephen J. Choi, Do the Merits Matter LessAfter the Private Securities Litigation Reform Act?, 23 J.L. ECON. & OCRG.598 (2007).

109 S. REP. No. 104-98, at 9 (1995), reprinted in 1995 U.S.C.C.A.N.679, 688. Lawmakers described an "in terrorem effect on CorporateAmerica" of shareholder class action litigation. Costs of defending againstlawsuits "added significantly to the cost of raising capital and represent a'litigation tax' on business." Id.

110 Senator Alfonse M. D'Amato, Republican of New York and asupporter of the PSLRA, offered this definition of a "strike suit":


discourage the filing of "frivolous" actions alleging securitiesfraud and to enable defendants to terminate litigationquickly by filing a motion to dismiss.'

The legislation responding to the perceived threat ofabusive litigation included two critical steps relevant here.First, lawmakers added a requirement that lead plaintiffs insecurities class action lawsuits be investors with substantiallosses. 11 2 Adoption of this requirement sought to precludelitigation controlled by lawyers whose clients were verysmall investors-perhaps holding just one or two shares ofthe defendant corporation-by ensuring that a large

A strike suit occurs when a lawyer searches very carefullyfor negative news announcements by a company or adecline in a company stock price. Then these lawyers raceto the courthouse to file a suit alleging securities frauds,alleging mismanagement, or misinformation. I look to mycolleagues on the floor from Alaska for an analogy-thereis gold in the hills if a firm offers a security. There arelawyers who are mining that gold for themselves.Sometimes, even if a stock price goes up, lawyers will raceto bring suits because they allege that they were not giveninformation that this company would have higher earningsthan anticipated. Imagine. If there is bad news, you arevulnerable. If there is good news, you are vulnerable.

141 CONG. REC. S8885, S8891 (daily ed. June 22, 1995) (statement of Sen.Alfonse M. D'Amato). While he did not specify that his concern was classaction litigation, the examples he cited involved class action lawsuits, andother senators criticized the lack of client input in securities lawsuits,arguing that lawyers for a class of plaintiffs actually controlled cases. Forexample, Senator Paul Sarbanes said that "plaintiffs' attorneys appear tocontrol the settlement of the case with little or no influence from either the'named' plaintiffs or the larger class of investors." Id. at S8894.Provisions of the PSLRA other than the changes to pleading standardsattempted to address this issue.

111 H.R. REP. No. 104-369, at 32 (illustrating that, to combat "abusivesecurities litigation," the PSLRA "implements needed proceduralprotections to discourage frivolous litigation").

112 15 U.S.C. § 78u-4(a)(3)(B)(iii)(I)(bb) (2012) (requiring courts topresume that "the most adequate plaintiff in any private action" is theinvestor who "has the largest financial interest in the relief sought by theclass," but permitting another member of the class to challenge thepresumption).

8 1No. I1:47] HURDLES OF DIFFERENT HEIGHTS

investor, presumably with the expertise, incentive, andability to control litigation strategy, would oversee thelawsuit. The "lead plaintiff' provision was aimed squarelyand precisely at the potential problem of abusive shareholderclass actions.

The second step taken by Congress in the PSLRA was notso narrowly tailored. Lawmakers selectively raised pleadingrequirements applicable not just to suits by shareholders orto class action suits, but to any private litigation allegingsecurities fraud. The PSLRA requires that a plaintiffs"complaint ... specify each statement alleged to have beenmisleading, the reason or reasons why the statement ismisleading, and, if an allegation regarding the statement oromission is made on information and belief, the complaintshall state with particularity all facts on which that belief isformed."113 The PSLRA further requires the plaintiff to"state with particularity facts giving rise to a stronginference that the defendant acted with the required state ofmind,"114 and put on the plaintiff the burden of establishingloss causation.11 5 The PSLRA did not raise the standard thatclaims of reliance must meet.1 16

The imposition of special pleading requirements, moredemanding than those for other civil claims, aided corporatedefendants in disposing of claims before incurring the cost of

113 See 15 U.S.C. § 78u-4(b)(1).114 See id. § 78u-4(b)(2)(A). In adopting the PSLRA, lawmakers

focused on curbing "frivolous" shareholder class action lawsuits, and thehigher standards specified in the legislation appear to have focused on theelements of a claim more likely to be relevant to that class of litigation.

115 See id. § 78u-4(b)(4).116 This is not to say that lawmakers did not have the issue of reliance

on their minds; they almost certainly did, because a few years earlier, theSupreme Court endorsed the "fraud on the market" theory of reliance,which aided shareholder plaintiffs in fraud lawsuits. See Basic Inc. v.Levinson, 485 U.S. 224, 250 (1988). Courts have recognized that relianceis not subject to a heightened pleading standard. See, e.g., In reCountrywide Fin. Corp. Sec. Litig., 588 F. Supp. 2d 1132, 1198 (C.D. Cal.2008) (finding reliance element subject to the lower standard of Rule 9(b)"because it is one of the 'circumstances constituting fraud' not subject toPSLRA standards").



complying with discovery requests (and potentially trial).Lawmakers thus intentionally put more risk onto plaintiffsthat purchased securities, making it more difficult for suchinvestors to survive a defendant's motion to dismiss. Thelegislative record suggests that lawmakers intended the shiftto block meritless claims; they did not consider the possibleeffects on incentives that might change investor behavior,such as the incentive to take more care before buying."'

Judges have not focused on the incentives created by thepleading standards either, although they have questionedthe degree of care exercised by plaintiffs who boughtsecurities and then challenged the transaction. The partythat enters a transaction with closed eyes cannot later claimto have fallen victim to fraud; the law permits recovery onlyby an investor who behaves reasonably. Securities fraudsuits involving sophisticated investors force courts to engagein a line-drawing exercise, distinguishing cases in which theplaintiffs' efforts to protect themselves from fraud werereasonable from those in which they were unreasonable."'In the former cases, defendants' motions to dismiss may bedenied; in the latter, granted. This scheme makes sense ifviewed as reflecting an unstated, but nevertheless clear,moral judgment: although a fraud may ensnare the prudentalongside the careless, only the former deserves theprotection of the law.11 9 The availability of recovery through

117 Indeed, at least one scholar has suggested that one result of thePSLRA was underdeterrence of securities fraud because the law made itless likely that potential plaintiffs would sue. See Barbara Black,Eliminating Securities Fraud Class Actions Under the Radar, 2009COLUM. Bus. L. REV. 802, 816-17 (2009) (describing the impact of hurdlesCongress erected to claimants alleging securities fraud).

11s See C. Edward Fletcher III, Sophisticated Investors Under theFederal Securities Laws, 1988 DUKE L.J. 1081 (1988) (providing athorough canvassing of courts' treatment and mistreatment of themeaning and significance of investors' sophistication through the 1980s).

119 This is a longstanding principle embodied in law governing bothfederal and state securities fraud claims. See Zobrist v. Coal-X, Inc., 708F.2d 1511, 1518 (10th Cir. 1983). Professor Sachs has argued that theunreasonable reliance on a fraudulent statement should not result in afinding of no liability because such an outcome undermines the

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the courts is itself an incentive to take care because, at leastin theory, the courts aim to help those who have alreadytried to help themselves.

Lawmakers also did not discuss how this step wouldaffect plaintiffs suing as individuals rather than as a class.Put another way, the choice of which elements of a fraudclaim would face a higher pleading standard was not madebased on an explicit determination that tougheningparticular elements would narrowly target shareholder classactions but not other types of litigation alleging securitiesfraud. The legislative record contains no hint of such arationale. 120 Nor, for that matter, does the legislative record

effectiveness of the securities law in addressing fraud. See Sachs, supranote 93, at 106-07.

120 Proving a negative claim is difficult, but public records oflegislative proceedings preceding the enactment of the PSLRA do notreveal discussion of this issue. Instead, lawmakers focused on thepotential harm of shareholder class action litigation. The HouseConference Report stated:

[A]busive practices committed in private securitieslitigation include: (1) the routine filing of lawsuits againstissuers of securities and others whenever there is asignificant change in an issuer's stock price, without regardto any underlying culpability of the issuer, and with onlyfaint hope that the discovery process might lead eventuallyto some plausible cause of action; (2) the targeting of deeppocket defendants, including accountants, underwriters,and individuals who may be covered by insurance, withoutregard to their actual culpability; (3) the abuse of thediscovery process to impose costs so burdensome that it isoften economical for the victimized party to settle; and (4)the manipulation by class action lawyers of the clientswhom they purportedly represent.

H.R. REP. No. 104-369, at 31 (1995) (Conf. Rep.), reprinted in 1995U.S.C.C.A.N. 730, 730. One supporter of the PSLRA referred to companies"abused by a handful of lawyers," and quoted then-SEC chairman ArthurLevitt, who criticized shareholder class action lawsuits for "simplytransfer[ring] wealth from one group of shareholders, those who are notmembers of the plaintiff class, to another group of shareholders." 141CONG. REc. H2749, H2752 (daily ed. March 7, 1995) (statement of Rep.Jack Fields). Another supporter complained that a "strike suit plague isdevastating our Nation." Id. at H2753 (statement of Rep. Michael Oxley).

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contain findings that lawsuits by investors in privateplacements are more or less likely to be frivolous and/ormore or less likely to siphon corporate defendants' resourcesfrom more productive uses. Congress did not consider thepotential systemic costs of litigation by connected investors.As a result, it has not addressed, for example, whether thepleadings of connected investor plaintiffs, who claim greatinvesting expertise, 12 1 should meet a higher standardbecause they should be less vulnerable to seller deception.

At the time, popular and congressional attention did notfocus on lawsuits arising out of private placements. It tookthe financial crisis of 2008, which spawned litigation pittingfinancial companies that were party to private placementsagainst one another, to provoke any degree of scrutiny. Inpassing the PSLRA, lawmakers did not intend to hamper

In contrast, opponents of the bill warned that the PSLRA would not"protect the interests of the honest, innocent and small investors," addingthat:

[U]nder the requirements for Scienter in the pleadings inthis legislation a person who has been wronged bysecurities fraud will need not only a layer [sic] but he willneed a psychiatrist and a psychic to tell him what wasgoing on inside the mind and head of the wrongdoer.

Id. at H2754 (statement of Rep. John Dingell). But that is as close asanyone got to addressing the potential impact of the revisions on thepleading standards on different types of investors.

121 Many financial companies purchase securities through privateplacement transactions, in which sellers sell securities under anexemption to registration requirements of the Securities Act. See THOMASP. FITCH, DICTIONARY OF BANKING TERMS 356 (6th ed. 2012). Section 4 ofthe Securities Act exempts certain securities transactions fromregistration requirements, 15 U.S.C. § 77d (2012), and SEC Rule 506, forexample, permits an issuer to sell securities through private placements tono more than 35 buyers who are "capable of evaluating the merits andrisks of the prospective investment." 17 C.F.R. § 230.506(b)(ii) (2013).The underlying idea is that investors who can protect themselves andabsorb potential losses should be allowed to engage in transactionsdeemed too risky for the less savvy or less wealthy. A buyer purchasingsecurities not registered with the SEC is likely to receive transaction-specific documents useful in the event of ex post litigation.



outsider claims relative to connected investors' claims.1 2 2

But, as this Article will show, their choice of which pleadingstandards to raise had that effect. 123

Instead of focusing on the potentially disparate effects ofthe PSLRA, opponents of the law warned that it would hurtvictims of securities fraud generally. Senator Paul Sarbanescautioned that as a result of the PSLRA, "[i]ndividualinvestors, local governments, pension plans, all will find itmore difficult to bring fraud actions and to recover their full

122 Scholars have commented on and criticized the differentialimpacts of procedural rules. Some have indeed called for moresophistication in pleading standards, shifting away from a uniform systemin which claimants comply with the same procedural rules regardless ofthe nature or size of the case. See, e.g., Stephen N. Subrin, TheLimitations of Transsubstantive Procedure: An Essay on Adjusting the"One Size Fits All" Assumption, 87 DENV. U. L. REV. 377, 394 (2010)(arguing for three different "tracks" applicable to claims). Such a shiftwould have the virtue of making explicit the political nature of proceduraldecisions, as Professor Subrin notes. Id. at 384 ("If one requires, forinstance, more rigorous pleading in securities cases in order to make suchcases more difficult to bring, it is hard to say this is not a political decisionwith substantive results."). However, it is far from clear that thecombination of selectively raised pleading standards and relative access topotential evidence is the result of reflection, or that it is fair that aninformation-advantaged claimant, like a connected investor, shouldeffectively face a less demanding pleading standard.

123 Scholars have analyzed other effects of the PSLRA. Michael A.Perino finds that the legislation had an effect on shareholder class actions,but that the effect was mixed. Whether the goal of the legislation wasachieved likely depends on one's view of what the goal was: the number ofshareholder suits did not decline, but the "quality" of the cases filed mayhave risen. Michael A. Perino, Did the Private Securities LitigationReform Act Work?, 2003 U. ILL. L. REV. 913, 976 (2003). A survey ofstudies on the impact of the PSLRA concluded that the effect of thePSLRA was more modest, finding that "there are as many securities classaction filings now as before" and that while dismissal rates rose(consistent with Professor Perino's interpretation of the data), more thantwo-thirds of suits still ended with a settlement. RICHARD PAINTER, MEGANFARRELL & Scorr ADKINS, PRIVATE SECURITIES LITIGATION REFORM ACT: APOST-ENRON ANALYsIS 17 (2002) available at https://www.fed-soc.org/docib/20070323_PSLRAFINALII.PDF. Unlike this Article, botharticles focused on class action claims.

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damages as a result of this legislation."124 Senator Sarbanesdid not distinguish between class action lawsuits andindividual suits, between retail and institutional investors,between shareholders and holders of other types ofsecurities, or between outsider investors who bought inpublic offerings on exchanges and connected investors whodid so through private placements. Lawmakers could havedeliberately distinguished between lawsuits brought byoutsider investors and connected investors, but they did not.The standards apply alike to individual investors,institutional investors, and to investors aggregated in aclass; they also apply to investors in publicly accessibletransactions and investors in private placements. 125

However, the effects of the selective raising of pleadingstandards are not so equitable.

IV. IMPLICATIONS OF SELECTIVELY RAISINGPLEADING STANDARDS FOR OUTSIDER

INVESTORS

The preceding discussion described the pleadingrequirements applicable to claims of securities fraud. ThisPart describes the implications.

Because successfully alleging scienter is a criticalchallenge for outsider investor claimants, raising the

124 141 CONG. REC. S8885, S8900 (daily ed. June 22, 1995) (statementof Sen. Paul Sarbanes).

125 Although the tougher standards imposed by the PSLRA apply toinvestors large and small, they address the kind of facts plaintiffs mustallege, and in many cases pose a more significant hurdle to claims byshareholders than to claims by financial institutions. For this reason,courts at times disaggregate securities fraud actions, addressingshareholder claims and financial institution claims in separateproceedings. Judge Mariana Pfaelzer consolidated securities claimsagainst the defendant in three cases: shareholder litigation, derivativelitigation, and litigation initiated by qualified institutional buyers. See Inre Countrywide Fin. Corp. Sec. Litig., 588 F. Supp. 2d 1132, 1142 n.2 (C.D.Cal. 2008). The court isolated the third set of claims "because itanticipated that reliance issues in the private placement market-the fraudon the market presumption and actual reliance-would raise uniqueissues." Id.

HURDLES OF DIFFERENT HEIGHTS 87No. I1:47]

standard for that element makes outsiders' claims moredifficult to substantiate. Connected investors who purchasedsecurities through a private placement and subsequentlyallege fraud benefit from a more hospitable legalenvironment because the challenge for them is more likely tobe demonstrating reasonable reliance, and lawmakers didnot raise the standard applicable to claims of reliance.126

The first section of this Part describes how the selectiveraising of pleading standards affects different kinds ofinvestors. It describes two cases involving allegations ofsecurities fraud, one initiated by holders of publicly tradedshares and the other by purchasers of securities that werenot publicly traded, to show how different pleadingstandards create a higher hurdle for outsider investors. Thesecond section identifies some of the risks of requiringdifferent kinds of plaintiffs to meet different standards whenmaking similar claims.

A. Selectively Raising Pleading Standards BurdensOutsider Investors

Plaintiffs filing securities fraud lawsuits face a difficultchallenge. They must tell a persuasive story about the

126 One could imagine a different regime in which sophisticatedinvestors who purchased publicly traded shares were held to a higherstandard than other, smaller scale investors, even when alleging fraud onthe market. This approach makes sense because sophisticated investorsshould be better able to evaluate publicly traded stocks, just as theyshould be better able to make decisions about other private transactions.This is not, however, the path that courts have taken, instead finding thata successful allegation of fraud on the market is sufficient to establishreasonable reliance for a securities fraud plaintiff whether sophisticated ornot. This highlights some of the inconsistency that persists in courts'treatment of sophistication. That inconsistency has been surveyedthoroughly by Professor Fletcher, see supra note 118, but in some keyrespects his article is out of date; namely, it was written before it becameclearer that the question of reasonable reliance is distinct from causation.See Dura Pharm., Inc. v. Broudo, 544 U.S. 336, 341 (2005) (stating that"reliance [is] often referred to in cases involving public securities markets(fraud-on-the-market cases) as 'transaction causation') (citing Basic Inc.v. Levinson, 485 U.S. 224, 248-49 (1988)).

88 COLUMBIA BUSINESS LAW RE VIEW [Vol. 2014

defendant's alleged misconduct, citing specific evidencewithout the benefit of discovery. This evidence mustovercome the demanding standards described in Part IIIabove. In the typical shareholder lawsuit, plaintiffs startwith regulatory filings and public remarks by corporateexecutives to analysts or reporters, then contrast thosedisclosures and subsequent revelations against the truecondition of the company, its product, or some otherdevelopment relevant to the defendant's business. Withoutmore, perhaps from a confidential informant or inadvertentdisclosure of insider discussions, the plaintiffs mustessentially argue that executives had to know of the falsity ofthe public statement or regulatory filing on which investorsrelied.

For connected investors, gathering evidence of adefendant's intent is less difficult because privatetransactions are typically preceded by presentations,informal exchanges of e-mail messages, provision of detailedprospectuses, and, sometimes, supporting data. This is thecase regardless of whether the seller in the privateplacement is a publicly traded company or has a differentcorporate form. 12 7 A review of more than 100128 resolutionsof motions to dismiss section 10(b) claims in the SouthernDistrict of New York found that in all of the lawsuits filed by

127 Publicly traded companies may choose, for various reasons, to sellsecurities through private placements. At the height of the financialcrisis, Goldman Sachs & Co., sold $5 billion in preferred stock to BerkshireHathaway through a private placement. See Susanne Craig, MatthewKarnitschnig & Aaron Lucchetti, Buffett to Invest $5 Billion in Goldman;Famed Investor's Move Is Seen as a Vote of Confidence in Crisis-StrickenBanking System; Old Ties to Firm Paved Way for Deal, WALL ST. J., Sept.24, 2008, at Al.

128 The initial review covered 213 judicial decisions made between2008 and May 2012 to resolve motions to dismiss in the Southern Districtof New York, the most active securities litigation docket in the UnitedStates. See LEGALMETRIc, LEGALMETRIC CUSTOM REPORT: MOTIONS TO

DISMIss IN SECURITIES CASES (SELECTED DISTRICT) (2012) (on file withauthor). This list of cases covers a time period intended to capture post-financial crisis litigation. These numbers are still preliminary; I continueto analyze the cases included in the sample.

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investors who purchased through private placements, theplaintiff cited such transaction-specific documents to supporta claim. 129

In the following subsection, a typical case involvingshareholder allegations of securities fraud is described. Thecase illustrates the relative difficulty of meeting the pleadingstandards imposed on different types of claimants allegingsecurities fraud.

1. Outsider Investors' Difficulty DevelopingEvidence of Scienter

After the onset of the financial crisis in 2008,shareholders of the bank holding company Wachovia filed afraud lawsuit alleging violations of section 10(b), amongother wrongs.1 30 The plaintiffs claimed that they purchasedWachovia stock as a result of false and misleadingstatements by the bank and its executives about its exposureto potential losses on home loans. Thus, shareholdersalleged that when the housing market declined and defaultrates among borrowers rose, shareholders were caught bysurprise and suffered losses as the price of a Wachovia share

129 Drawing conclusions about the impact of access to this informationon the success of a plaintiffs claim is very difficult, because the effect isunlikely to be manifested only through the decision of a judge decidingwhether to grant a motion to dismiss. Investors who purchased throughprivate placements may be more likely to initiate litigation in the firstplace, relative to investors who bought publicly accessible securities; thiswould be consistent with findings by some scholars that the quality ofshareholder class action claims may have risen as plaintiffs and theirlawyers adjusted to the PSLRA's requirements. See Perino, supra note123, at 915.

130 See In re Wachovia Equity Sec. Litig., 753 F. Supp. 2d 326(S.D.N.Y. 2011). A critical element was Wachovia's purchase of GoldenWest Financial Corporation ("Golden West"), a mortgage lender based inOakland, California, in 2006; while Wachovia before the acquisition mademostly traditional, fixed-rate home loans, Golden West's "main product"was an adjustable rate mortgage, which "allowed borrowers to choose frommultiple payment options each month." One of the options was making apayment that did not cover the monthly interest due, thereby increasingthe outstanding principal balance of the home loan. Id. at 342.

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fell below $1.131 The evidence cited by shareholders includedpublic statements by Wachovia executives extolling thecompany's "conservative underwriting" standards inextending home loans, describing the "superior creditquality" of the company's mortgage portfolio, andemphasizing that the company "actively managed ourbusiness to minimize our exposure to the subprimemarket."132 These statements, made between 2006 and early2008, gave way in 2008 to disclosures of losses on home loansas borrowers defaulted. 13 3 The bank's market value fell by$109.8 billion between early 2007 and the third quarter of2008. 134

The stumbling block for the plaintiffs was establishingscienter to satisfy the PSLRA's high standard. WhenWachovia and the Wachovia executives named in thecomplaint moved to dismiss the action, 3 5 the plaintiffs hadto support their claim that the defendants knew that theirpublic statements were false. Judge Richard Sullivanoutlined two paths to sufficient allegations of scienter: (1)showing that the defendants had "motive and opportunity" todefraud, or (2) offering "strong circumstantial evidence ofconscious misbehavior or recklessness." 3 6 Considering thefirst option, Judge Sullivan observed that the defendantsclearly had the opportunity to defraud. 1 37 A showing ofmotive was more difficult because any employee would havehad an incentive to improve an employer's prospects andsomething more was necessary. 3 8 The plaintiffs tried to use

131 The price of shares of the company fell by at least seventy-fourpercent in 2008. See Eric Dash and Andrew Ross Sorkin, Regulators Pushfor Sale of Wachovia, N.Y. TIMEs, Sept. 29, 2008, at Al5. Wachovia wasultimately acquired by Wells Fargo in 2008. See Wachovia, 753 F. Supp.2d at 343.

132 Id. at 342-43.133 Id. at 343.134 Id.135 Id. at 346.136 Id. at 348.137 Id. at 349.138 Id.

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evidence of stock sales by insiders to show motive. Theyargued that defendants hid the risks to the company untilthey sold their shares."' But Judge Sullivan noted thatregulatory filings showed that, overall, the defendantWachovia executives increased their stock holdings in theperiod of the alleged fraud. 4 0 In any event, stock sales were,at best, indirect indicators of motive. The judge similarlydisposed of the argument that executives masked poorfinancial performance in order to enable a corporateacquisition'4 1 or to boost their own compensation. 142

Judge Sullivan found that the plaintiffs had similarlyfailed to allege sufficient facts showing recklessness becausethey could not show that, at the time that Wachoviaexecutives made the allegedly false and misleadingstatements about the bank's lending practices and potentiallosses, the executives knew or should have known that thestatements were untrue.1 4 3 For example, the plaintiffs failedto "specify which reports [to the executives] revealed thewidespread lending problems."'4 4 Confidential witnessesrelied upon by the plaintiffs failed to state that they sharedany concerns with senior executives such that they wouldhave been on notice of potential problems; the lack ofcommunication "undermine[d] the inference that Defendantsrecklessly disregarded the truth about Wachovia's mortgageportfolio while publicly trumpeting the virtues of' itsloans.145

139 Wachovia, 753 F. Supp. 2d at 349.140 Id141 The timing did not work because the acquisition in question

involved Golden West: executives had no reason to inflate stock pricesafter the merger was consummated. Id. at 350.

142 Id. at 351-52 ("[I]f scienter could be pled on the sole basis ofexecutive compensation, 'virtually every company in the United Statesthat experiences a downturn in stock price could be forced to defendsecurities fraud actions."' (quoting Acito v. IMCERA Grp., Inc., 47 F.3d 47,54 (2d Cir. 1995)).

143 Id. at 352.144 Id.145 Id.

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Without the benefit of discovery, Wachovia shareholdersdid not have access to internal documents, e-mail messages,reports, or other materials that might have shown either (a)that executives at the bank actually realized the degree ofexposure to losses on home loans and deliberately concealedboth the financial reality and their knowledge of it, or (b)that executives should have known of the company'sexposure in light of information provided to them, and werereckless in not recognizing the potential losses. Unlikeparticipants in private placements, the plaintiffs did nothave transaction-specific documents containing allegedlyfalse descriptions of asset quality that could be compared tothe truth. Because the plaintiffs did not successfully allegescienter, Judge Sullivan dismissed the shareholders'claims.1 46 There was thus no investigation into whether theyhad adequately pleaded the other elements of securitiesfraud.147

2. Connected Investors' Allegations of Reliance

146 Wachovia, 753 F. Supp. 2d at 366-67 (finding that "Plaintiffs havefailed to plead facts giving rise to a strong inference that Defendants actedwith the intent 'to deceive, manipulate, or defraud.' The more compellinginference, at least based on the facts as they are alleged in the complaints,is that Defendants simply did not anticipate the full extent of themortgage crisis . . . . Although a colossal blunder with grave consequences

for many, such a failure is simply not enough to support a claim forsecurities fraud" (citation omitted)).

147 The example here is not meant to signal that every shareholderclaim founders on the shoals of scienter. See, e.g., In re MBIA, Inc., Sec.Litig., 700 F. Supp. 2d 566, 590-91 (S.D.N.Y. 2010) (finding plaintiffshareholders adequately alleged scienter on part of corporate defendant, ifnot individual executives, in making public statements about potentialexposure to losses resulting from exposure to rising rates of default onhome loans); In re CIT Grp. Inc. Sec. Litig., No. 08 Civ. 6613(BSJ), 2010WL 2365846, at *4 (S.D.N.Y. June 10, 2010) (finding plaintiff adequatelystated a § 10(b) claim based on recklessness by alleging that defendants"knew about CIT's lowered lending standards-and, in some cases,affirmatively approved them-while publicly touting the company's'conservative' and 'disciplined' approach to subprime lending; and . . .learned of the deterioration of CIT's home loan and student loan portfolios,while making public statements indicating that CIT was outperformingthe market and would suffer only minimal losses").

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Face a Less Demanding Standard

The pleading standard applicable to claims of reasonablereliance, which is less demanding than that applicable toallegations of scienter, correspondingly benefits connectedinvestors. Here, briefly, is a description of a case thatillustrates the standard that allegations of reasonablereliance must clear. 14 8

An investment company with a sole managing member,Dodona I LLC ("Dodona"), purchased securities in 2007 witha face value of $4 million from Goldman, Sachs & Co.("Goldman"). 149 The value of the securities depended on theperformance of assets, selected by Goldman, which in turndepended on repayment of residential mortgages.1 5 0 Dodonasold the securities less than one year after the purchase,losing more than ninety percent of the value of theinvestment. 151 Dodona sued, alleging violations of section10(b) and common law fraud, among other wrongs. 152 Theplaintiff charged that Goldman deliberately constructed thesecurities in a way that ensured they would lose value;Dodona claimed that the transaction had shifted the risk oflosses due to increased home loan defaults from Goldman tothe purchasers of the securities. 153 Goldman moved todismiss Dodona's lawsuit, contending that Dodona wascrying "fraud by hindsight" because there was no way thatGoldman could have known with certainty how the value of

148 The case described is not a class action, unlike the shareholderlawsuit against Wachovia discussed above. In analysis of the impact ofthe pleading standards, however, this distinction does not make adifference because the same requirements must be met for an individualaction as for a class action.

149 Dodona I, LLC v. Goldman, Sachs & Co., 847 F. Supp. 2d 624, 635(S.D.N.Y. 2012).

150 Id. at 634.151 See Amended Class Action Complaint for Violation of the Federal

Securities Laws and New York Common Law at j 162, Dodona I, LLC, v.Goldman, Sachs & Co., No. 10 Civ. 7497 (V1VI), 2011 WL 1297951,(S.D.N.Y. Feb. 4, 2011).

152 Dodona I, 847 F. Supp. 2d at 635-36.153 Id. at 645-46.

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the underlying home loans might change1 54 and that Dodona,as a sophisticated investor, could not have reasonably reliedon alleged omissions in information provided about thesecurities. 155 For example, Goldman noted that Dodonareceived information on credit scores and average loan-to-value ratios of borrowers whose home loans backed thesecurities underlying the securities sold.1 56 Goldman arguedthat Dodona was sophisticated enough to have determinedon its own the risk of defaults and resulting losses on themortgage-linked securities but had failed to avail itself of theopportunity, and should not be permitted to recover throughlitigation.15

Judge Victor Marrero did not grant Goldman's motion todismiss. He concluded that Dodona had adequately allegedscienter by presenting evidence of Goldman executives'determination to reduce the company's own exposure to therisk of losses caused by defaults on home loans.1 58 Therecord included excerpts of e-mails that Dodona had obtainedin which at least one Goldman employee derided the qualityof the assets underlying the securities.15

1 Judge Marreroconcluded that Goldman omitted material information whenit failed to disclose the riskiness of the securities.160

In discussing whether Dodona reasonably relied onalleged misstatements and omissions by Goldman, JudgeMarrero noted that the plaintiffs complaint "ratherconspicuously avoids discussing the nature of Dodona'sbusiness or making any representations regarding Dodona'slevel of sophistication."1 6 1 And whether Dodona was asophisticated investor or not, Judge Marrero wrote, "it isunclear to the Court whether 'the information necessary tounmask the alleged fraud [would] have been accessible to the

154 Dodona I, 847 F. Supp. 2d at 644.155 Id. at 648.156 Id. at 648.157 Id.158 Id. at 646.159 Id. at 642.160 Id. at 645.161 Id. at 648.

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sophisticated party through minimal diligence."' 16 2

Permitting the case to proceed to discovery was appropriateto determine both whether Dodona was sophisticated andwhether sophistication would have mattered in detecting thefraud alleged. 16 3

The case illustrates judges' discretion in evaluating thereasonableness of a plaintiffs claimed reliance on anallegedly fraudulent statement or omission. If a higherstandard had applied to this element of a claim of fraud, theplaintiffs complaint almost certainly would have had toinclude at least some representation regarding itssophistication and some description of the steps taken toprotect itself from potential losses. But no such"particularity" was necessary and the case proceeded.' 6 4

The descriptions above are not meant to suggest that allclaims by connected investors succeed. They have not. 6 1

Nor do I mean to suggest that an investor who purchasessecurities through a private placement establishes ipso factothat reliance on an allegedly fraudulent statement oromission was reasonable. But I do suggest that connectedinvestors, unlike outsider investors who may typicallyreceive only information contained in regulatory filings orother public statements, often receive transaction-specific

162 Dodona I, 847 F. Supp. 2d at 649 (quoting Terra Sec. ASAKonkursbo v. Citigroup, Inc., 740 F. Supp. 2d 441, 449 (S.D.N.Y. 2010)).

163 Id.164 As of January 23, 2014, the case was active. Jonathan Stempel,

Judge Rules Goldman Must Face Class-Action Lawsuit by Investors,REUTERS, Jan. 23, 2014, available at http://www.reuters.com/article/2014/01/23/us-goldman-cdo-classaction-idUSBREAM1JQ20140123.

165 See, e.g., Terra Sec. ASA Konkursbo v. Citigroup, Inc., 450 F.App'x 32, 34-35 (2d Cir. 2011) (dismissing claims by plaintiffs other thanNorwegian municipalities because they were "clearly sophisticatedinvestors" and they did not allege "that they conducted any independentinvestigation prior to making their investments"). See also LandesbankBaden-Wurttemberg v. Goldman, Sachs & Co., 821 F. Supp. 2d 616, 624(S.D.N.Y. 2011) (dismissing common law fraud claim because plaintiffsfailed to allege particular fraudulent statements and dismissing negligentmisrepresentation claim because plaintiff "represented that it was asophisticated investor and had adequately researched and accepted therisks associated with its . . . investment").

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information of a type that is not available to the general,investing public. That information is particular to thetransaction in a way that, for example, disclosures in anannual report cannot be and do not claim to be. Thesetransaction-specific documents illustrate, at a minimum, adefendant seller's interest in persuading the plaintiffinvestor to participate in the deal. Any incentive to mislead,then, is the result of a desire to conduct a particulartransaction with a specific investor, and not only of a moregeneral desire to benefit the seller.

B. Negative Consequences of Favorable PleadingStandards for Connected Investors

The law's different demands of securities fraud claimantsbased on characteristics of their investments have significantconsequences, not least because of the rapid growth inprivate offerings in recent years. 1 66 In this section, I firstidentify the potential systemic consequences of favoringcertain claims and/or claimants, and then place thedifferential treatment in the larger context of increasinglydemanding requirements facing plaintiffs in civil litigationgenerally.

1. Lower Reliance Standards May DiscourageInvestor Care

The potential systemic effects of smoothing the road torecovery for connected investors is arguably a great concern.The prospect of recovery through litigation could makeprivate transactions more appealing than they already are,resulting in further growth in private placements. Thebenefit of that outcome is unclear. Connected investors mayinvest less in due diligence before participating in riskyfinancial transactions of precisely the sort that maycontribute to financial crises,16 7 and executives of companies

166 See Ivanov and Bauguess, supra note 13, at 1 (describing the"significant increase in use of private market capital").

167 Of course, individual corporate executives with a role in managinginvestment practices may still lack an incentive to take due care on behalf

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selling such transactions may have too great an incentive toengage in socially wasteful, fraudulent conduct. Thepopularity of private transactions may grow yet further as aresult of the greater likelihood of recovery through litigationin the event of seller misconduct.16 8 If one goal of regulatorsis to foster systemic stability, then creating stronger ratherthan weaker incentives to conduct due diligence makessense, because it is in the best interest of all who depend onwell-functioning markets that investors avoid taking on toomuch risk. Otherwise, the danger persists of recreating theconditions that preceded the 2008 financial crisis: excessiveparticipation in risky transactions despite a significantpossibility that the outcomes of investments will adverselyimpact not just counterparties but also the ability offinancial markets to function. Taxpayers smarting from thegovernment's emergency steps to protect financial companiesafter the 2008 crisis may well want to promote a healthysense of caution in the investors who participated intransactions involving mortgage-linked securities.

When purchasers of securities obtain recoveries, theyhave succeeded in putting the burden of losses on sellers,'and the resulting distribution of risk may not reflect theunderlying intent of the PSLRA. It seems unlikely thatjudges resolving individual motions to dismiss take into

of an employer. Compensation practices are a part of the story of thefinancial crisis. For a more complete discussion of the role of suchincentives, see Donald C. Langevoort, Chasing the Greased Pig Down WallStreet: A Gatekeeper's Guide to the Psychology, Culture, and Ethics ofFinancial Risk Taking, 96 CORNELL L. REV. 1209, 1212 (2011) (observingthat, for example, portfolio managers might have knowingly decided toinvest their principals' money in poor quality assets linked to home loansbecause the managers "had compensation-based incentives to deliberatelyignore the long-term risk").

168 Whether further growth in popularity of private transactions is agood thing is a question beyond the scope of this paper, but certainly somescholars have questioned the trend in that direction in recent years. SeeRodrigues, supra note 17, at 3392.

169 This shifting of risk from buyers to sellers may actually have theeffect of concentrating systemic risk. See Robert A. Brown, FinancialReform and the Subsidization of Sophisticated Investors' Ignorance inSecuritization Markets, 7 N.Y.U. J.L. & BUS. 105, 173 (2010).

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account the systemic incentive effects of their rulings, or thatjudges are better placed than lawmakers to determine howrisk ought to be allocated generally between buyers andsellers of securities. Congress, I suggest below, should takeup this task-bearing in mind that changes might affect thebehavior of would-be and actual fraudsters.170 Theperpetrator of a fraud might engage in wrongful conductmore readily if recovery by the victim is more difficult. Butpost-crisis litigation complicates that story; in many of thosecases, buyers alleging fraud did receive disclosures fromsellers and later either contended that the disclosure wasinsufficient or confessed that they did not review theinformation with care. If defendants consistently won insuch lawsuits, then the incentive to disclose would remainstrong, because disclosure would protect sellers by making itharder for investors to succeed with their claims. Indeed, itis the incentive effect for connected investors that moststrongly supports refinement of the standard applicable topleading of reasonable reliance.

2. Raising Pleading Standards for OutsiderInvestors as Part of the Trend of RestrictingCivil Recovery

At a higher level, the more demanding pleading standardfor outsider investors is but one example of barriers toredress through civil litigation. Scholars have identifiedother mechanisms that effectively narrow access to thecourthouse for certain potential civil claimants, thus makingthe securities fraud issue discussed in this Article part of alarger phenomenon.17 1 Examples of other mechanisms

170 It is difficult to predict how future perpetrators of fraud will reactto any change in legal regime; fraud takes advantage of change to exploitthe ignorant, and change itself - let alone the opportunities change creates- can be difficult to predict. See Samuel W. Buell, Novel Criminal Fraud,81 N.Y.U. L. REV. 1971, 2015-16 (2006).

171 See, e.g., Catherine Albiston, The Dark Side of Litigation as aSocial Movement Strategy, 96 IOWA L. REV. BULL. 61, 69-74 (2011) (notingthat the courts are an ineffective vehicle for social reform); Marc Galanter,Why the "Haves" Come Out Ahead: Speculations on the Limits of Legal


include judicial decisions favorable to litigants whomProfessor Marc Galanter identified as "repeat players," whocan choose when to settle and when to litigate with an eyetoward generating precedents likely to hinder futureopponents. 17 2 Additionally, some observers identify recentSupreme Court decisions describing-and, in the eyes ofcritics, raising-the standard plaintiffs must meet whenalleging violations of constitutionally protected rights,1 73 orwhen alleging conduct that, while not fraudulent, wouldviolate the law.1 7 4 Yet another example is legislationdemanding that plaintiffs show the strength of their case atearly stages in the proceedings, such as the PSLRA.175

The Supreme Court has raised hurdles for civil plaintiffsin particular contexts. 1 76 In Ashcroft v. Iqbal, the SupremeCourt evaluated the claims of a Pakistani citizen who wasarrested and detained in the United States and who claimedthat he suffered abuse while in government custody. TheCourt concluded that the plaintiff had not alleged sufficient

Change, 9 LAw & Soc'y REV. 95, 113 (1974) (discussing how thosefrequently engaged in litigation manipulated court rules and createdbarriers to civil claimants); Arthur R. Miller, From Conley to Twombly toIqbal: A Double Play on the Federal Rules of Civil Procedure, 60 DUKE L.J.1, 9 (criticizing creation of additional procedural barriers for plaintiffs);Judith Resnik, Constricting Remedies: The Rehnquist Judiciary, Congress,and Federal Power, 78 IND. L.J. 223, 231 (2003) (explaining how thejudiciary is prevented from granting remedies).

172 Plaintiffs' lawyers may be repeat players in one sense, but theirinterest in winning a large fee award in any given case may notnecessarily cause them to adopt a long-term view of the most favorablelegal precedent to try to generate. See Galanter, supra note 171, at 102.

173 See Ashcroft v. Iqbal, 556 U.S. 662, 686 (2009) (laying out theproper pleading standard).

174 See Bell Atl. Corp. v. Twombly, 550 U.S. 544, 556 (2007) (settingthe pleading standard for illegal conduct).

175 See supra Part III.C (describing legislative requirements thatsecurities fraud pleadings must meet to survive a motion to dismiss).

176 The cases doing so have generated considerable commentary; see,e.g., Miller, supra note 171, at 68, 71 (criticizing higher barriers to courtsfor civil plaintiffs).


facts to survive a motion to dismiss.1 7 7 Two years earlier, inBell Atlantic Corporation v. Twombly, the Court reached asimilar conclusion about consumers' allegations of antitrustviolations by companies providing telephone and Internetservices. However, neither Iqbal nor Twombly involved Rule9 of the Federal Rules of Civil Procedure because neithercase involved allegations of fraud; and because neither caseinvolved a claim under section 10(b), neither had to satisfythe PSLRA. While consistent with the trend towardrestricting access to the courts, Iqbal and Twombly differsignificantly in context from the securities claims that arethe subject of this Article.

Critics contend that these barriers to judicial remediesblock claims that deserve adjudication on their merits. In anarticle lambasting the trend, Professor Arthur R. Millerargues that the tougher stance adopted by the SupremeCourt in recent years is the result of "too much attentionpaid to claims by corporate and other defense interests ofexpense and possible abuse and too little on citizen access, alevel litigation playing field, and the other values of civillitigation."" His arguments are consistent with whatProfessor Galanter would have predicted forty years earlier:repeat players, such as corporations, with the wealth to

177 Describing the standard that a plaintiffs claim must meet toovercome a motion to dismiss, the Court, citing to Twombly, wrote:

[A] complaint must contain sufficient factual matter,accepted as true, to state a claim to relief that is plausibleon its face. A claim has facial plausibility when theplaintiff pleads factual content that allows the court todraw the reasonable inference that the defendant is liablefor the misconduct alleged. The plausibility standard is notakin to a probability requirement, but it asks for more thana sheer possibility that a defendant has acted unlawfully.Where a complaint pleads facts that are merely consistentwith a defendant's liability, it stops short of the linebetween possibility and plausibility of entitlement to relief.

1qbal, 556 U.S. at 678 (citations and internal quotation marks omitted).This standard clearly differs from that required under Rule 9 and thePSLRA.

178 Miller, supra note 171, at 2.

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retain excellent representation, have succeeded in tilting theplaying field against their potential opponents.'7 9

Scholars chronicling a decline in accessibility of legalredress paint a bleak picture, describing those who areblocked from the courthouse doors do not have the politicalor economic clout to improve their status. However, in theaftermath of the 2008 financial crisis, large, wealthyfinancial institutions that were outsider investors have suedequally wealthy and powerful adversaries. As a result, apowerful constituency might favor changes to pleadingstandards. The financial crisis has blurred historical battlelines, which in the past clearly divided investor plaintiffs andtheir advocates, on one side, from corporate defendants andtheir officers and directors, on the other. Corporatedefendants in the years leading up to passage of the PSLRAsuccessfully characterized their situation as dire and in needof legislative intervention, but with the rise of financialcompany plaintiffs after 2008, corporate interests may havebecome more diverse. An opportunity may therein lie formodification of fraud pleading standards.

179 See Galanter, supra note 171, at 97. Erecting barriers to civilplaintiffs generally would be concern enough, but others warning of such atrend have described an effort to hinder vindication of civil rights inparticular. Catherine Albiston uses militaristic language, describing an"attack on civil rights." She identifies, as evidence, a variety of judicialmoves, such as expanding the scope of sovereign immunity andrestrictions placed on the activities of legal services lawyers. SeeCatherine R. Albiston & Laura Beth Nielsen, The Procedural Attack onCivil Rights: The Empirical Reality of Buckhannon for the Private AttorneyGeneral, 54 UCLA L. REV. 1087, 1131 (2007). She does not discusslitigation by aggrieved investors, who may appear to be less sympatheticvictims. However, differential treatment of claimants in a manner thatfavors the powerful should be considered in this context: why shouldinvestors in private placements, who have considerable resources at theirdisposal and who affirmatively choose to take advantage of exemptions tootherwise applicable disclosure regimes in their pursuit of higher rates ofreturn, enjoy an easier path to recovery than investors who purchasepublicly accessible securities?

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V. PROPOSING NEW STANDARDS

The preceding discussion suggests that pleadingstandards applicable to securities fraud claims are too lowfor investors in securities purchased in private placements.This criticism implicates the regulatory framework thatclassifies investors, permitting only some investors toparticipate in private placements. I have also suggested thatthe effects of too-low standards are undesirable, in partbecause of the negative incentive effects on connectedinvestor due diligence. Regulation has failed to keep pacewith the changing characteristics of financial markets, therise of institutional investors, and the growth of privateofferings.s 0

This Part proposes ways to address the problemsidentified. Creating fair playing fields for investors holdingsecurities of different types requires two sets of changes.First, pleading standards demand review, with an eyetoward reducing the burden on shareholders alleging fraudby demanding less evidence of wrongful intent to survive amotion to dismiss.181 Second, what constitutes reasonablereliance requires reconsideration-not to hinder plaintiffsthat invested in private placements, but rather to ensureadequate pre-transaction diligence.

A. Reducing the Hurdle's Height for Pleading Scienter

Correcting the pleading standards requires recognitionthat the rationale permitting recovery by connected investorsis no different from the justification for recovery by outsiderinvestors. The path to recovery should be as smooth for thetypical outsider individual, retail investor, or pension fund,as it is for a connected financial company investor engaged in

180 See Ivanov and Bauguess, supra note 13, at 3.181 An alternative would be to raise the standard applicable to

assertions of reasonable reliance by putatively sophisticated investors-amove decisively criticized by Professor Sachs more than twenty-five yearsago. See Sachs, supra note 93, at 107.

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proprietary trading, in order to permit claims with merit toproceed. 182

Therefore, the standard applicable to allegations ofscienter should be lowered, in recognition of the differingabilities of differently situated plaintiffs to obtain theinformation necessary to plead with particularity. Pleadingstandards should not exacerbate the informationaladvantages of connected investor plaintiffs relative tooutsiders. Readopting Rule 9(b) of the Federal Rules of CivilProcedure as the guiding and binding standard for claims ofsecurities fraud, without the higher standard of the PSLRA,would ensure that plaintiffs making viable accusations offraud litigate on the same playing field, regardless ofinvestor or investment.

Pleading standards might also be made more specific, toenable analysis of the reasonableness of reliance byplaintiffs.' In litigation arising out of private placementsales, plaintiffs who purchased securities could be requiredto describe at the pleading stage the due diligence theyconducted, the reasoning underlying that level of duediligence, the extent to which they followed their own pastpractice and/or standard industry practices, and the reasonsfor any deviations.1 84 This amendment would shift risk to

182 If the lead plaintiff requirement has led to filing of higher-qualitycases, see Perino, supra note 123, at 976, then, in this way, securitieslitigation by shareholders can better achieve deterrence of misconduct.See John C. Coffee, Jr., Reforming The Securities Class Action: An Essayon Deterrence and its Implementation, 106 CoLUM. L. REV. 1534, 1535-36(2006) (identifying the "fundamental problem" of securities class actionlitigation as the failure either to compensate victims of fraud or deterpotential wrongdoers).

183 Or, as Professor Sachs has suggested, this analysis-requiringreview of due diligence by an investor-could be jettisoned as inconsistentwith the goal of deterring, detecting, andlor punishing fraud. See Sachs,supra note 93, at 131.

184 The goal of requiring such a statement would be prophylactic: therequirement of a description would force executives to think beforehand,explicitly and specifically, about the nature and degree of due diligenceperformed, helping to counter any tendency to rely on longstandingpractice or unquestioned assumptions. For a comprehensive discussion ofthe potential role of intellectual biases on decision-making prior to the

COL UMBIA B USINESS LA W RE VIE W [Vol. 2014104

purchasers from sellers. While lawmakers, who lackexpertise, should not presume to tell businesspeople how toevaluate investment opportunities, they may reasonablyrequire plaintiffs to describe the evaluation they performed.

Sophisticated investors would have to explicitly identifythe potential weaknesses of the due diligence approachtaken-the sources of risks of error in evaluation-anddescribe the representations and warranties demanded ofthe seller in order to address those weaknesses. Investorswould have to justify any failure to obtain suchrepresentations and warranties. Together, thesedocumentation requirements would force investors to thinkcarefully before entering a transaction and, afterward, wouldpromote consistency among judges evaluating whetherplaintiffs alleging fraud were reasonable in relying on theinformation they obtained. The requirement makes shiftinglosses from buyers to sellers through litigation more difficult.

This is not, per se, a call for a tougher pleading standardapplicable to assertions of reliance, but rather a descriptionof a more precise pleading standard that judges could applyconsistently when evaluating whether a plaintiffs relianceon an allegedly fraudulent statement or omission wasreasonable.' 5 Plaintiffs would have to describe industry

financial crisis, see Geoffrey P. Miller and Gerald Rosenfeld, IntellectualHazard: How Conceptual Biases in Complex Organizations Contributed tothe Crisis of 2008, 33 HARv. J.L. & PUB. POL'Y 807 (2010); see also TomC.W. Lin, A Behavioral Framework for Securities Risk, 34 SEATTLE U. L.REV. 325, 362-63 (2011) (discussing a proposal with similar goals). If aninvestor did not conduct due diligence, then that investor's claims wouldhave great difficulty obtaining the aid of the court in obtaining redress-although judges would have to retain discretion in evaluating deviationsfrom industry practice and in evaluating the wisdom of industry practicesthemselves.

185 Professor Karmel has advocated adopting a presumption ofreasonable reliance in cases based on the theory of fraud on the market,but the proposal is limited to cases involving allegations of fraudulentstatements or omissions in regulatory filings. See Roberta S. Karmel,When Should Investor Reliance Be Presumed in Securities Class Actions?,63 Bus. LAw. 25, 53-54 (2007). The proposal would not, then, address thedisparate treatment of claims by shareholders relative to claims by othertypes of investors.



practices and compare those practices to the steps taken toconduct due diligence. Judges would consequently haverelevant benchmarks for evaluating claims, as well asexplanations of deviations. Judges would still retaindiscretion in deciding whether a particular degree ofdeviation should preclude the possibility of recovery, orwhether an industry norm is itself dubious, but potentialplaintiffs would at least consider how to justify choices madeabout due diligence and would likely demand more extensiverepresentations and warranties from sellers.

Precision-not the same as particularity, and not restingon information inaccessible to the plaintiff-would notdiscourage all lawsuits. Shareholder litigation did not ceasefollowing the enactment of the PSLRA. And following anywidespread financial catastrophe, institutions that losemoney will almost certainly seek mitigation of losses throughlitigation. The argument made here is not that thislitigation should be prevented. Rather, the goal is betterallocation of risk between the parties and quicker dispositionof those cases in which sophisticated, connected investors didnot take adequate steps to protect themselves from potentiallosses before deciding to participate in transactions. Theeffect would be a reallocation of risk to buyers in privateplacements from sellers, encouraging buyers to be morecautious and, perhaps, more conservative. This shouldcounter the possibility that sellers would not care aboutoutcomes subsequent to a sale; buyers would have a strongerincentive ex ante to investigate an investment carefully.1 8 6

The clear costs of this shift would be the burden of satisfyingthe requirement of the pleading standard in any litigation,the cost of due diligence that a buyer might otherwise nothave conducted, and perhaps the cost of transactions thatmight not transpire at all.

186 The price mechanism ought to achieve this same effect. However,buyers may not consciously bargain for a lower price based on a decisionnot to conduct due diligence, unless forced to grapple with the question ofhow much diligence is due.

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B. Reforms Are Possible

Changing the procedural requirements imposed onclaimants requires legislative and regulatory action.Lawmakers, who in the past have attempted to balance theinterests of aggrieved buyers against those of sellers, couldbetter determine the pleading standard that should apply toinvestors in private placements. Perhaps they would havedone so in the PSLRA, had anyone pointed out thatconnected investors may engage in litigation as "frivolous" asan abusive shareholder class action lawsuit. In the wake ofthe financial crisis, lawmakers required more detaileddisclosure of the characteristics of assets underlyingtransactions,18 ' but those rules will not compel buyers toreview the information provided. With the benefit ofinformation on the effects of changes to pleading standardson all players in the industry, lawmakers are well-positionedto draw a line between sellers' duty to disclose and buyers'duty to investigate. What lawmakers require is a spur toact.

There is reason to think they might find one. Whilepublic companies supported the barriers to investor claims inthe PSLRA,18 8 businesses would likely be less unified insupport of modifying requirements applicable to fraud claimsinvolving securities sold through private placements.Increasing diversity of investors may make it easier tomodify the pleading standards, both by lightening theburden imposed on plaintiffs who are outsider investors and

187 See Dodd-Frank Wall Street Reform and Consumer Protection Act,Pub. L. No. 111-203, § 942(b), 124 Stat. 1376, 1897 (2010) (codified atU.S.C. § 77g (2012)) (ordering the SEC to adopt regulations "requiringeach issuer of an asset-backed security to disclose, for each tranche orclass of security, information regarding the assets backing that security,"including disclosure of "asset-level or loan-level data, if such data arenecessary for investors to independently perform due diligence").

188 See S. REP. No. 104-98, at 4 (1995), reprinted in 1995 U.S.C.C.A.N.679, 683 (referring to "substantial testimony" from numerous executives ofpublicly traded companies who criticized the pre-PSLRA treatment ofshareholder claims as unduly favorable to plaintiffs and burdensome todefendant corporations).

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by specifying the requirements imposed on connectedinvestors' claims that their reliance on allegedly fraudulentstatements or omissions was reasonable. After all, largeinvestors are both shareholders of companies that they haveaccused of committing fraud and also investors in privateplacements. The magnitude of financial crisis-related lossesforced institutional investors who formerly might havehesitated to participate in investor litigation an incentive tosue. As a result, the front in favor of the current pleadingregime's standards for allegations of scienter is likely lessunited than it was before the financial crisis. At the sametime, any argument that the standards applicable to claimsof reasonable reliance should be more precisely defined islikely to find enthusiastic support among defendants inlitigation involving securities sold through privateplacements. Lowering barriers to outsider investor plaintiffsmay encounter less resistance now than in the past, andimposing consistency on connected investor plaintiffs' claimsof reasonable reliance may find more support today than itdid previously.

VI. CONCLUSION

This Article argues that different pleading standards fordifferent elements of claims of securities fraud affectinvestors in distinct ways, depending on the context of thepurchase. For outsider investors, the scienter element of afraud claim poses special difficulty. Scienter is subject to theheightened pleading standards of the PSLRA, which requiresplaintiffs to present facts sufficient to create a "stronginference" of wrongful intent. 1 89 For investor plaintiffs whopurchase a security through a private placement, thereliance element poses a more significant hurdle. Plaintiffsmust establish that their reliance on an allegedly fraudulentstatement or omission was reasonable. The moresophisticated the purchaser, the more difficult it may be todemonstrate reasonable reliance because a moresophisticated investor is expected to better detect warning

189 15 U.S.C. § 78u-4(b)(2)(A).

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signs of fraud. Reliance, however, is not subject to aheightened pleading standard.

This Article contends that pleading requirements shouldnot disfavor outsiders for two reasons. First, outsider andconnected investors have different degrees of ability toprotect themselves ex ante from fraud, and pleadingstandards should take this reality into account. Second,connected investors, perceiving greater ease of recoverythrough litigation in the event of a calamitous purchase, mayadopt too lax an approach to due diligence.

This Article suggests that judges weighing investors'claims probably do not and should not take into account thepotential incentive effects of their decisions. The Article hasproposed lightening the pleading burden that the currentlegal regime places on outsider investor claims in order tofacilitate the protection of investors who may have lessaccess to information. In addition, it has proposed requiringconnected investors to document the due diligenceundertaken prior to investing in a private placement as aprerequisite to asserting the reasonableness of their claimedreliance on an allegedly fraudulent statement or omission.The PSLRA already imposes a significant and effectiveconstraint on potentially abusive securities class actionlitigation by favoring large, institutional investors, such asstate pension funds, in controlling roles in lawsuits.O

190 The PSLRA presumes that the most desirable lead plaintiff in ashareholder class action lawsuit is the investor who has the greatestfinancial interest in the outcome of the case-typically a large financialinstitution rather than an individual investor. The presumption seeks toprevent lawyers, whose interests might diverge from those of investors,from controlling the litigation: a large institution would have the meansand the incentive to monitor counsel. An empirical analysis of the effect ofthe lead plaintiff provision by Professor Perino finds that involvement ofinstitutional investors in shareholder class actions causes at least some ofthe beneficial effects intended by lawmakers in 1995. When publicpension funds are lead plaintiffs, settlement amounts are larger, andattorney fee requests and fees actually awarded are lower. See MichaelPerino, Institutional Activism Through Litigation: An Empirical Analysisof Public Pension Fund Participation in Securities Class Actions, 9 J.EMPIRIcAL LEGAL STUD. 368, 390 (2012).



Fraud victims who are outsider investors deserve a fairchance at recovery.

Documents

hurdles of different heights for securities fraud litigants of different